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Sector Detector: Positioned for Continued Market Strength

Tue, May 4, 7:16 PM ET, by Scott Martindale, Sabrient.com

Scott Martindale

Four times over the past month, the stock market has threatened to pullback strongly after such a long and impressive upward march. The first three times (April 16, 27, and 30), it found a strong bid around the 20-day moving average to make each a one-day event, which investors treated as entry points into a continued bull market. However, some technicians have been warning of a topping formation – because market tops are rarely a sudden event but rather a process. This finally might be the real thing.

Sabrient's quantitative SectorCast-ETF model employs a fundamentals-based multi-factor approach including forward valuation, earnings growth prospects, recent analyst consensus sentiment, and various return ratios. Overall, the model still looks mostly bullish – despite the aforementioned topping formation at hand.

If I'm reading the SectorCast model correctly, all the ducks are lining up for this pullback to be a buying opportunity. The economically-sensitive sectors are strengthening relative to the defensive ones. However, the one possible fly-in-the-ointment is Consumer Discretionary, which has fallen in the rankings. But this might be because it has been the strongest performing sector over the past month, and the other economically-sensitive sectors are merely trying to catch up.

Latest rankings: The rankings are based on Friday's close, so they won't reflect today's sell-off. Nevertheless, these are relative rankings, and the significant price correction in the more economically-sensitive sectors will likely strengthen their rankings – unless the analysts come out with sudden downgrades, which is unlikely.

The rankings have changed very little since last week. Financials (XLF) and InfoTech (IYW) remain at the top with the same scores as last week, 70 and 69, respectively. Both continue to see more analysts increasing earnings estimates. Also, XLF is strong in projected price/earnings ratio, while IYW is strong in return on equity.

Top-ranked stocks within XLF and IYW include Assurant (NYSE: AIZ), SLM Corp (NYSE: SLM), Ingram Micro (NYSE: IM), and Lexmark (NYSE: LXK).

The most notable sector movers are Industrials (XLI) and Materials (XLB), which rose to pass up Consumer Discretionary (XLY), even though XLY scored the same 53 as last week.

Also notable is the fact that the spread between the top and bottom sectors is increasing again. After being in the 65-point range a few months ago, it had recently tightened to only 22 points. This week, we see it has widened to a 35-point spread, mainly due to the continued drop in Telecom.

Yes, Telecommunications (IYZ) has really solidified itself at the bottom of the rankings as it has weakened even further in its projected year-over-year change in earnings across the stocks in the sector. The real killer, however, is the increase in the net number of analysts reducing earnings estimates. In fact, every other sector ETF in the Sector Detector table received a net increase in analyst consensus estimates. Only the stocks within the IYZ saw deterioration in this important metric.

Also in the bottom two this week is Consumer Staples (XLP). Although, as a defensive sector, it held up relatively well on a big down day like today, its score fell slightly while other sectors like XLI saw improvement. It sports a strong return on equity, but it is quite weak in projected year-over-year change in earnings.

Low-ranked stocks within XLP and IYZ include McCormick & Co. (NYSE: MKC), Proctor & Gamble (NYSE: PG), Verizon (NYSE: VZ), and Level 3 Communications (Nasdaq: LVLT).

These scores represent the view that Financials and InfoTech stocks may be relatively undervalued overall, while Telecom and Consumer Staples stocks may be overvalued.

Performance: The table below shows the performance of each of the prior four weekly portfolios as of the market close on Tuesday, 5/4/2010. Each portfolio assumes that the top two ETFs are entered long and the bottom two are entered short, all at the opening prices on Wednesday.

Overall, performance is holding up as well or better than a straight long position on the market. But of course, this absolute return portfolio is intended to make a profit in all market conditions. Although the XLF, XLV, and XLE all are showing relatively strong valuations and fundamentals, they each have been hindered by external news events surrounding Goldman Sachs (and banking in general), Healthcare legislation, and the big offshore oil blowout in the Gulf of Mexico – none of which is captured in the model.

Nevertheless, given the potential topping formation of the market and today's strong sell-off, it seems like a good bet to stick with such an absolute return approach.

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

About SectorCast: The rankings are based on Sabrient's SectorCast model, which builds a composite profile of each of the ten ETFs in the table below based on bottom-up scoring of their constituent stocks. The model employs a fundamentals-based multi-factor approach including forward valuation, earnings growth prospects, analyst revisions, and various return ratios.

SectorCast has tested to be highly predictive for identifying the best (most undervalued) and worst (most overvalued) sectors, with a one-month forward look. 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 eight Select Sector SPDRs, but because the SPDRs combine InfoTech and Telecom into one ETF, I use the two iShares for those sectors rather than the SPDR Select Technology ETF.

About Trading Strategies: Sector Detector has shown how you can use this information in three ways to identify ETFs that have the potential to enhance your upside, downside, or market-neutral trading ideas. First, if you are bullish on the broad market, you can go long the SPDR Trust exchange-traded fund (SPY), which tracks the S&P 500 Index, and enhance it with long positions in SectorCast's 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 really don't want to bet on which way the market is going, you could try a market-neutral, long/short trade—that is, go long the top-ranked ETFs and short 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.

About Performance Tracking: I track each week's set of ETFs (2 longs and 2 shorts) as a mini-portfolio over the course of four weeks. Because SectorCast does not include any technical triggers, this will give the fundamentals-based model a chance to achieve its predicted move.


SDI Glossary: "price" Definition
SDI Glossary: "ETFs" Definition
SDI Glossary: "iShares" Definition
SDI Glossary: "NYSE" Definition
SDI Glossary: "Sector" Definition
This Article's Word Cloud:   About   Consumer   Detector   ETFs   However   NYSE   Sector   SectorCast   Telecom   approach   based   bottom   each   earnings   enhance   estimates   formation   forward   fundamentals   have   like   long   market   might   model   month   more   other   over   portfolio   projected   ranked   rankings   return   sector   sectors   sensitive   short   stocks   strong   table   that   this   week   which   while   will   with   within   year

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