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Sector Detector: Investors Hoping for a Bigger Pullback

Posted on the 05 April 2012 by Phil's Stock World @philstockworld

Sector Detector: Investors hoping for a bigger pullback

Bulls have struggled to keep the ball rolling during the past couple of days of uninspiring news. After Monday’s ISM data showed strength in the manufacturing sector, the S&P 500 hit another 52-week high, before selling set in for Tuesday-Wednesday. It seems the hawkish tone of the FOMC meeting minutes coupled with tepid demand for the latest Spanish debt offering was just a bit more than bulls could overcome. Like we saw with Greece’s debt situation, global investors have serious doubts that Spain has the fortitude to sustain the necessary fiscal reform.

Nevertheless, round-number resistance-turned-support levels at 13,000 on the Dow, 3000 on the Nasdaq, and 1400 on the S&P 500 have held up through Wednesday, although the S&P 500 closed slightly below support. The S&P 500 index has fallen eight of the past twelve sessions, and the Nasdaq posted its worst daily percentage decline for 2012. Nine of the 10 sector iShares are lower for the first three days of the week, with Materials (IYM) and Energy (IYE) the weakest and defensive sector Utilities (IDU) the only one staying positive.

The “junk rally” phase that the market has reached generally precedes a significant pullback to remind  investors about the importance of quality when choosing a good stock investment. In fact, I think bulls are eager for a bigger pullback as a much needed retest of key support levels from which to build a foundation…and to put more cash to work at lower prices.

The first quarter of 2012 closed with stocks achieving their strongest quarterly gains since 1998. The S&P 500 was up 12%. Utilities, which was the best performing sector during 2011, was the worst performer for 1Q2012. Financials and Technology were the quarter’s best performers. Tech was led by Apple (AAPL), of course, which was up an amazing 48%–accounting for more than a third of the S&P 500’s gain for the quarter.

Looking at the SPY chart, it closed Wednesday at 139.86, which is just below the 140 resistance-turned-support level. It is testing support at the near-term uptrend line (since late December). Below that, there is support from the longer-term uptrend line around 137. RSI, MACD, and Slow Stochastic all have a ways to go to work off overbought conditions and cycle back down to oversold.

Sector Detector: Investors hoping for a bigger pullback

The VIX (CBOE Market Volatility Index—a.k.a. “fear gauge”) closed Wednesday at 16.44, which is still well below the important 20 threshold. 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 40 bps, where it has held flat since mid-February. This appears to be the level or credit risk at which investors are comfortable.

With yields so low, Treasuries remain overvalued. For yields to rise prices have to fall, which means selling—and the likely transfer of capital into equities and other risk assets. So, if Europe can hold things together, and if the impending earnings season is reasonably encouraging, there’s no reason that the growing legions of bulls can’t take the S&P 500 to 1500 within the next several months. Unless the bottom falls out on high volume (likely due to an major external event), taking out important support levels, “buy the dip” will remain the working mantra.

After all, the world depends on it. Despite what you hear about the rapid emergence of China, the U.S. remains the engine of global economic growth, especially given the struggles in Europe and Asian. The FOMC and the ECB both recognize this, which will keep them pumping the liquidity spigot and making riskier assets relatively attractive.

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: Investors hoping for a bigger pullback

Observations:

1. There is not a lot of change in the rankings as we head into earnings season next week. Technology (IYW) remains at the top of the Outlook rankings with an 83. IYW is particularly strong in its return ratios as margins remain high in tech products, but it is strong pretty much across the board on all relevant factors. Only its projected P/E is mediocre, as prices continue to soar within the sector.

2. Financial (IYF) widened its lead over Healthcare (IYH) for second place with a score of 78. IYW and IYF are now well above the pack. They also are getting the most support from Wall Street analysts, along with Industrial (IYJ).

3. Energy (IYE) and Materials (IYM) continue to be beaten down and now reflect the lowest projected P/Es. IYM in particular continues to get hit with net earnings downgrades from Wall Street.

4. Telecom (IYZ) remains at the bottom of the rankings with a 4. IYZ remains saddled with the worst return ratios and the highest projected P/E. It is again joined in the bottom two by Utilities (IDU) with a score of 21. IDU has poor long-term growth projections and relatively high projected P/E.

5. Looking at the Bull scores, Financial (IYF) has been the clear leader on strong market days, scoring 56. With its consistent recent performance, Technology (IYW) has risen to 50. Utilities (IDU) is by far the weakest on strong days, scoring 34.

6. As for the Bear scores, IDU is the investor favorite “safe haven” on weak market days, scoring 59, followed by IYK at 57. IYM shows by far the lowest Bear score of 33. This means that Basic Materials stocks tend to sell off the most when the market is pulling back.

7. Overall, IYW still shows by far the best combination of Outlook/Bull/Bear scores. Adding up the three scores gives a total of 185. But IYF is close behind at 183. IYZ is by far the worst at 96. IYF now shows the best combination of Bull/Bear with a total score of 105. IYE and IYM share the worst combination with a dismal 84.

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

Top ranked stocks within Technology and Financial sectors include F5 Networks (FFIV), Gartner Inc. (IT), BB&T Corp (BBT), and HomeStreet Inc. (HMST).

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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