ETF Update: Health Care Legislation and Health Care Stocks

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 |  Includes: EWD, FCHI, FXI, GDX, HAO, IHF, IYH, PSAU, RYH
by: Jeff Miller

"What's the news?" is the first question when we see a big move in a stock or sector. There is always some reason, valid or not. Knowing the news explanation is an important step for those who trade on fundamentals.

After months on the national stage, the debate over health care reform has reached the final act. In the next few weeks we will know whether national policy will change, and the nature of that change. Meanwhile, the health stocks have been signaling "There's news" on a regular basis.

Let us first take a look at our approach to spotting emerging sectors.

Background

In our disciplined system, we study sectors continually, looking at the charts and ratings for hundreds of ETF's. Each week we provide a list of our top-rated sectors for the next three weeks, along with some of our current observations. ETF investors can check out the list and compare our findings with their own conclusions.

In our analysis, we consider Trends, Cycles, and a bit of Anticipation. Since we apply the model to nearly 300 ETF's, we call it the TCA-ETF system. (For new readers, there is a more complete description of our methods at the end of the article. We also have a free report with more detail on the system and results, available on request.)

The model also provides a nice feel for the overall potential of the market. I'll take a look at the macro picture first, and then take a look at our featured sector of the week.

The Macro View

From an overall market viewpoint, our indicators have improved. The key elements are as follows:

  • 55% of our ETF's in positive territory ( up from 31% last week). The median strength rating for the overall list is a plus 1 (up slightly from -6 last week). A score of "0" implies the average long-term ETF expectancy.
  • 97% (up from 93%) of our sectors are in the "penalty box." This means that they are currently disqualified from the buy list for technical reasons. You can think of this as a sophisticated "stop loss" rule, often applied in advance. See our article here for a further explanation of this method.
  • Our index package is neutral, but leaning positive. For this rating we look at the ETF's (both long and short) for the S&P 500, the Dow, and the Nasdaq. You can see these ratings is the results table for this week.

Spotlighting Health Care

Our ETF universe has several health care choices, but the fastest-moving is the Rydex S&P Equal Weight Health Care ETF (NYSEARCA:RYH). ETF expert Tom Lydon notes that, as opposed to other health care ETF's, RYH emphasizes small and mid-cap holdings. RYH has a diverse holding including 52 stocks. The P/E is 20.4 and the price-to-book is over 3. The beta is currently 1.0, but we expect it to move higher as the health care legislation progresses.

Health care stocks have responded mostly to the market, but partly to the twists and turns of health care legislation. Here is the chart for RYH (click to enlarge). The charts for other choices -- IHF and IYH -- are similar.

Ryh

This is a key situation. We would not be surprised to see the sector pop out of our "penalty box" for a purchase this week. This may depend upon the health care legislation.

A Look at the Fundamentals

Health care stocks have operated under a cloud because of the ongoing debate over reform legislation. Analyzing public policy and the impact on stocks is our sweet spot, so this could be a special opportunity in the weeks to come. Here is what you need to know and where to look for more information.

The Basics. Major legislation is a process of coalition-building. The result is a compromise program that no one really loves. It goes with the territory in a representative democracy. We expect our representatives to angle for legislation that reflects the needs of their districts.

This concept -- the formation of a minimal winning coalition -- is well-established political theory. Interested readers should check out William H. Riker's seminal work from 1962. There is a long political science literature on the theory of the minimal winning coalition. To build a majority, the coalition adds provisions that attract the marginal voter. That voter, honestly and wisely representing his/her district, bargains for provisions in the new law.

I understand that opponents of health legislation are calling this bribery. This is as old as the hills. You can find legislative examples from many countries and many eras -- all showing the same thing. To decry this form of coalition-building is the functional equivalent of condemning representative government. It merely means that the critic does not like the outcome, and therefore criticizes the process -- usually without any constructive alternative. It is not partisan, since all parties have used this approach.

The Implementation. I strongly recommend that investors put aside their opinions about the policy and focus on what stocks will benefit.

Where to Look. Our sister site, ElectionStocks.com, has extensive coverage of the health reform legislation and the potential stock impact. We expect a resolution of the health issue to help the entire sector. The market hates uncertainty, and this will be lifted. The health group may well emerge from our "penalty box."

Weekly TCA-ETF Rankings

We were mostly out of the market this week. The S&P lost a little ground and we did also on small positions.

We provide these ratings as information for readers who may not trade as frequently as we do. Those signing up for our free weekly email update can also get the entire list.

As noted above, the macro market indicators are in the penalty box, and most other ETF's are in the penalty box. Based upon the current model signals, we have continued our neutral position in the Ticker Sense Blogger Sentiment poll, despite the slight positive edge in the ratings.

Here are the top sectors from our expanded universe of 280 ETF's. The list also includes the values for the broad market ETF's and their inverses (click to enlarge).

112009

Note for New Readers

Our weekly ETF Update is designed to assist both investors and traders interested in ETF's and Sector Rotation. Before turning to the current rankings, let us undertake a review for readers new to this series.

Our Method. In this past article, we described our basic methodology and why we believe the rankings are useful for fundamental traders and technical traders alike. While we urge readers to check out the entire article, the key point is that ETF's pose challenges and opportunities different from investment in individual stocks. The fundamentals may be more difficult to assess. Even with a good grasp on fundamental trends, there is a lot of technically-based trading in ETF's. This means that those trading with a fundamental approach (and we do this as well) want to monitor the "hot money" moves. Here is an article on that point.

The system synopsis. We look at Trending sectors, Cyclical Sectors, and build in an element of Anticipation for both entry and exit -- thus the name of the model, TCA-ETF. While we do not reveal the exact methodology for spotting trends and cycles, the system is not a "black box." The basic elements are used by many, and widely reported. We even discuss the need for human analysis as opposed to black box trading.

We report the rankings each week, now on the weekend with a one-day delay, using the Thursday output from the model. We monitor and trade this daily, and offer a free report (request via the email address on the top left of the site) for those interested in our weekly trading program.