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Sector Detector: Fed Takes Over the Spotlight from Europe

Posted on the 21 June 2012 by Phil's Stock World @philstockworld

Sector Detector: Fed takes over the spotlight from EuropeGreece’s electorate has chosen to stay in the new world rather than retreat to the old. And the Federal Reserve has backed up its words regarding liquidity and accommodation to support economic recovery. That about sums up the latest news, which has helped the technical picture. Stocks have been able to break out of a holding pattern and continue the June rebound after a dismal May.

The Fed slightly lowered its growth forecast for the U.S. economy to 1.9-2.4% this year, and at the same time extended Operation Twist, which was to expire this month, by $267 billion. Some market observers think that this modest response was intended to signal confidence, since a more aggressive QE3-type of response may have been have given the impression that economic straits are dire.

As a reminder, Operation Twist is a program that swaps short-term bonds for longer durations, reducing interest rates on mortgages and business loans, i.e., provide cheap credit. However, at the same time, lenders have been more stringent with qualification, so borrowers have not necessarily found access to the cheap credit.

In addition, the Fed raised its forecast for the national unemployment rate, predicting it will end the year north of 8%–pretty much where it sits today. However, ConvergEx points out that the median rate when you go state-by-state is closer to 7.3%, and the massive state of California (where I live) is the biggest laggard at job growth. California is known for a lot of wonderful things, but business-friendly is not one of them.

SPY closed Wednesday at 135.48. The prior bear flag pattern shown was initially confirmed as June began, but the 200-day simple moving average provided immediate support, and the market has steadily rebounded. It had gone into a holding pattern between 131 and 134, as I discussed last week, awaiting its next catalyst to either break out or break down. This week we got the breakout. RSI, MACD, and Slow Stochastic oscillators have been forming higher lows, which was foretelling some anticipated bullishness.

Sector Detector: Fed takes over the spotlight from Europe

Now SPY finds itself at the upper Bollinger Band and back above its 50-day simple moving average (SMA), but hitting resistance at the 100-day. We could see a pullback to test resistance-turned-support at 134, or we could see a breakout above the 100-day SMA. In either case, bullishness is in the air.

And why not? When all the external news events are put aside, it is corporate earnings growth that most influence stock prices. Current estimates for the S&P 500 are near $104 per share, and bullish consensus from Wall Street analysts suggest even higher into next year. The S&P 500 at a 12.8 P/E ratio and forward estimates put it closer to 11, which appears quite bullish for stock prices given the historical P/E of around 14. The only concern here is the divergence between cautious economists and optimistic analysts.

“Don’t fight the Fed” is usually the operative phrase, and indeed the Fed’s policies have made stocks very attractive compared with the meager returns of cash and bonds. Today, the equity risk premium versus bonds is about double its historical level of around 3%. Unless the world financial system goes back into major crisis mode, this gap will likely close.

The TED spread (indicator of credit risk in the general economy, measuring the difference between the 3-month T-bill and 3-month LIBOR interest rates) closed Wednesday at 39 bps, holding the same level since mid-February. After showing a lot of range, last year, it has flatlined for so long that I’m beginning to wonder whether I should even watch this indicator any longer.

The VIX (CBOE Market Volatility Index—a.k.a. “fear gauge”) closed Wednesday at 17.24. After starting the month above 26, it has been falling while the market has rebounded, breaking down through the important 20 level on Monday with barely any hesitation and not looking back. Both VIX and TED are reflecting little in the way of investor worry.

I should mention that Gradient Analytics’ in-depth forensic accounting research was out in front of a number of stock blow-ups during the most recent earnings season, with negative grades on names like Alere (ALR), Accretive Health (AH), Mettler Toledo (MTD), International Rectifier (IRF), Semtech (SMTC), Akamai (AKAM), Quest Diagnostics (DGX), Diodes (DIOD), Universal Display (PANL), Netflix (NFLX), Cree (CREE), Wipro (WIT), Fossil (FOSL), AECOM Technology (ACM), Gentex (GNTX), and Rockwell Collins (COL).

In fact, on Wednesday, Goldman Sachs downgraded COL to a Sell rating. Gradient has retained its worst earnings quality grade of F for several months. Any portfolio manager (particularly long/short) who is not a subscriber to Gradient research is missing the boat, IMHO.

As a reminder, be sure to check out the latest edition of The MacroReport, which focuses on Global Oil. A co-publication of Sabrient Systems and MacroRisk Analytics, The MacroReport provides in-depth analysis of the macroeconomic trends in focus regions and how they might impact the U.S., with specific actionable ideas.

Each edition concludes with a series of economic factor-based ETF portfolios and “Quick Response” U.S. stock choices intended to capitalize on each scenario. The inaugural March edition focused on the Eurozone, while the April edition focused on China. The newest June issue looks at Global Oil.

Latest rankings: The table ranks each of the ten U.S. industrial sector iShares (ETFs) by Sabrient’s proprietary Outlook Score, which employs a forward-looking, fundamentals-based, quantitative algorithm to create a bottom-up composite profile of the constituent stocks within the ETF. In addition, the table also shows Sabrient’s proprietary Bull Score and Bear Score for each ETF.

High Bull score indicates that stocks within the ETF have tended recently toward relative outperformance during particularly strong market periods, while a high Bear score indicates that stocks within the ETF have tended to hold up relatively well during particularly weak market periods. Bull and Bear are backward-looking indicators of recent sentiment trend.

As a group, these three scores can be quite helpful for positioning a portfolio for a given set of anticipated market conditions.

Sector Detector: Fed takes over the spotlight from Europe

Observations:

1. Technology (IYW) again retains the top spot with an even stronger Outlook score of 89 this week, followed by Healthcare (IYH) at 77. Financial (IYF) comes in third at 70, as the top three have distanced themselves from the rest of the pack, with a 19-point gap down to fourth place Industrial (IYJ). The rankings still reflect an overall bullish bias, with the more economically sensitive sectors like Technology, Financial, Industrial, Consumer Services, and Basic Materials all in the top six. However, IYJ, IYC, and IYM all saw their scores fall since last week.

2. Utilities (IDU) and Telecom (IYZ) remain in the bottom two. IDU is saddled with the lowest long-term growth rate, and IYZ has the highest (worst) forward P/E. With Consumer Goods (IYK) in the bottom four, we see the defensive sectors mostly congregating at the bottom, which connotes a bullish outlook for stocks.

3. Looking at the Bull scores, Basic Materials (IYM) is now the clear leader on strong market days, scoring 60. Utilities (IDU) is by far the weakest on strong days, scoring 38. In other words, Materials stocks have tended to perform the best when the market is rallying, while Utilities stocks have lagged.

4. Looking at the Bear scores, Utilities (IDU) remains the investor favorite “safe haven” on weak market days, scoring an impressive 70, far distancing Telecom (IYZ) at 63. Although Materials (IYM) is the investor favorite on strong market days, it is abandoned (relatively speaking) during market weakness, as reflected by its low Bear score of 41. In other words, Materials stocks have tended to sell off the most when the market is pulling back, while Utilities stocks have held up the best.

5. Overall, IYW shows the best all-weather combination of Outlook/Bull/Bear scores. Adding up the three scores gives a total of 195. IYZ is the worst at 116. IDU and IYZ sit at the bottom of the Outlook rankings, which are heavily influenced by Wall Street projections, but these two sectors reflect the best combination of Bull/Bear at 108 (driven by their robust Bear scores). Consumer Services (IYC) and Materials (IYM) share the worst combination of Bull/Bear with a 101.

These scores represent the view that the Technology and Healthcare sectors may be relatively undervalued overall, while Telecom and Utilities sectors may be relatively overvalued, based on our 1-3 month forward look.

Top-ranked stocks within Technology and Healthcare sectors include Aware Inc. (AWRE), The Active Network (ACTV), Questcor Pharmaceuticals (QCOR), and HCA Holdings (HCA).

Disclosure: Author has no positions in stocks or ETFs mentioned.

About SectorCast: Rankings are based on Sabrient’s SectorCast model, which builds a composite profile of each equity ETF based on bottom-up scoring of the constituent stocks. The Outlook Score employs a fundamentals-based multi-factor approach considering forward valuation, earnings growth prospects, Wall Street analysts’ consensus revisions, accounting practices, and various return ratios. It has tested to be highly predictive for identifying the best (most undervalued) and worst (most overvalued) sectors, with a one-month forward look.

Bull Score and Bear Score are based on the price behavior of the underlying stocks on particularly strong and weak days during the prior 40 market days. They reflect investor sentiment toward the stocks (on a relative basis) as either aggressive plays or safe havens. So, a high Bull score indicates that stocks within the ETF have tended recently toward relative outperformance during particularly strong market periods, while a high Bear score indicates that stocks within the ETF have tended to hold up relatively well during particularly weak market periods.

Thus, ETFs with high Bull scores generally perform better when the market is hot, ETFs with high Bear scores generally perform better when the market is weak, and ETFs with high Outlook scores generally perform well over time in various market conditions.

Of course, each ETF has a unique set of constituent stocks, so the sectors represented will score differently depending upon which set of ETFs is used. For Sector Detector, I use ten iShares ETFs representing the major U.S. business sectors.

About Trading Strategies: There are various ways to trade these rankings. First, you might run a sector rotation strategy in which you buy long the top 2-4 ETFs from SectorCast-ETF, rebalancing either on a fixed schedule (e.g., monthly or quarterly) or when the rankings change significantly. Another alternative is to enhance a position in the SPDR Trust exchange-traded fund (SPY) depending upon your market bias. If you are bullish on the broad market, you can go long the SPY and enhance it with additional long positions in the top-ranked sector ETFs. Conversely, if you are bearish and short (or buy puts on) the SPY, you could also consider shorting the two lowest-ranked sector ETFs to enhance your short bias.

However, if you prefer not to bet on market direction, you could try a market-neutral, long/short trade—that is, go long (or buy call options on) the top-ranked ETFs and short (or buy put options on) the lowest-ranked ETFs. And here’s a more aggressive strategy to consider: You might trade some of the highest and lowest ranked stocks from within those top and bottom-ranked ETFs, such as the ones I identify above.


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