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Sector Detector: Financials Are a Drag

Posted on the 02 June 2011 by Phil's Stock World @philstockworld

Courtesy of Scott Martindale, Senior Managing Director, Sabrient

Sector Detector: Financials are a drag

We got a big red candle today in the stock market. Major indexes represented by SPY, MDY, and IWM are all resting on their 100-day moving averages and desperately scratching for support. Economically-sensitive sectors like Materials, Tech, and Industrial (represented by IYM, IYW, and IWJ) have fallen strongly below their 50-day and 100-day moving averages, while defensive sectors like Healthcare, Consumer Goods, and Utilities (e.g., IYH, IYK, and IDU) are faring better, finding support at their 20-day moving averages and well above their 50-day and 100-day MAs. Financial (IYF) is the worst off of all and appears to be in freefall, having now dropped to its lows for the year. But I wouldn’t suggest surrendering to the bears just yet.

What a difference a day makes. After yesterday’s strong performance in the face of disappointing economic reports, the market closed the month of May on a bullish note and back above all daily moving averages. But then today destroyed all of those happy vibes and put the SPY right back to where it was last Wednesday – sitting on its 100-day moving average and the uptrend line from December 1. The ADP Employment report and ISM Index fell short of expectations, and then Moody’s issued a late-day downgrade of Greek debt, which gave the dollar a little extra boost while further depressing equities.


Sector Detector: Financials are a drag

The main difference today from where SPY sat last week is that it experienced a false bullish breakout of a symmetrical triangle. RSI has zigzagged back below the neutral line while MACD failed in its attempt to make a bullish crossover.

So, SPY now sits at the convergence of the uptrend line, the 100-day moving average, and the lower Bollinger Band. Today’s big red candle on the first day of the month is reminiscent of March 1. You can see that after that big selloff on March 1, the market bounced briefly before falling through its 50-day MA and finding support at its 100-day, all within what might be described as a bull flag. Another bounce and another bull flag formed into April, and now the market finds itself trying to pick a direction from within the neutral symmetrical triangle.

Reports on jobless claims and the unemployment rate over the next two days should impact market direction. ConvergEx reported in their Morning Briefing that federal tax receipts from individuals are up significantly over last year at this time, which may bode well for the unemployment situation.

The market still has a lot of reasons to resume its uptrend, although the Financial sector will need to get onboard soon to help make it happen. There are even rumors starting to circulate about a “QE3” to keep stimulating the economy, but most observers believe that such a move at this point would be counterproductive, so I wouldn’t bet on it. The reinvestment of maturing securities should be sufficient fuel to support the markets and attract cash off the sidelines. But the biggest wild card is strength in the dollar, since a weak dollar has been quite favorable for stocks.

The TED spread (i.e., indicator of credit risk in the general economy, measuring the difference between the 3-month T-bill and 3-month LIBOR interest rates) closed at 21.22, which is up from last week but still relatively low in its range. Fear as measured by the CBOE market volatility index (VIX) rose steadily all day and closed at 18.30, which is still low in its range (note that it spiked as high as 48 last May).

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. 

Here are some notable observations in this week’s Sabrient’s SectorCast Outlook scores.

Sector Detector: Financials are a drag

1. Basic Materials (IYM) remains solidly in first place with an Outlook score of 97, as its valuations continue strong in the face of price weakness while analysts reaffirm their projections for stocks in the sector.  

2. Healthcare (IYH) regained the 10 points it lost last week to take a firm hold on second place with a 75, as analysts returned to support the constituent stocks. IYH joined IYM in having far-and-away the most analyst support this week. 

3. Strength in IYH came at the expense of Industrial (IYJ), which fell from 60 to 49 this week – basically making a roundtrip to where it was two weeks ago. I found last week’s strength in IYJ to be a welcome sign for the bulls, but that has moderated at least temporarily this week. 

4. We continue to see a 3-tiered ranking, in which IYM leads by a large margin, while six sectors (IYF, IYH, IYW, IYJ, IYK, and IYE) are still bunched in a relatively tight range in the middle (although they have spread out a bit more this week), and then IDU, IYC, and IYZ remain mired at the bottom. The bottom three are weighed down by poor support among analysts, high projected P/E, and in the case of IYC, poor return on sales as retail margins remain low. 

5. The Outlook rankings continue to reflect a cautiously bullish bent. The rise in Healthcare (IYH) at the expense of Industrial (IYJ) this week is somewhat disappointing, although there are a lot of stocks in Healthcare that have been strong market leaders. Also, the low score in Consumer Services (IYC) is worrisome. But otherwise, seeing scores above 50 for IYM, IYW, IYF, and IYE is modestly bullish.

Looking at the Bull scores, Energy (IYE), Industrial (IYJ), and Basic Materials (IYM), tend to lead on the strong market days. They are followed closely by Technology (IYW), Telecom (IYZ), and Consumer Services (IYC). Financial (IYF) continues to be the biggest laggard on strong market days, reflecting ongoing uncertainty in that sector, and that is worrisome. Financials will need to shape up if this market intends to resume its rally.

As for the Bear scores, Healthcare (IYH) and Consumer Goods (IYK) are the favorite “safe haven” sectors, followed by Utilities (IDU) and Telecom (IYZ). Energy (IYE) and Basic Materials (IYM), which sport some of the best Bull scores, have been the clear laggards on weak market days, reflecting quick abandonment among investors. 

Overall, Basic Materials (IYM) still displays the best combination of the three scores, but it now must share that honor with Healthcare (IYH). Adding up the three scores give both sectors a total score of 190. Healthcare (IYH) and Telecom (IYZ) enjoy the best combination of Bull/Bear, with a total score of 115. 

Top ranked stocks in Basic Materials and Healthcare include Stepan Company (SCL), Kronos Worldwide (KRO), Triple-S Management (GTS), and Jazz Pharmaceuticals (JAZZ).

Low ranked stocks in Utilities and Consumer Services include DigitalGlobe (DGI), Ormat Technologies (ORA), StoneMor Partners (STON), and (AMZN).

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

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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