Strong recent price performance has been found to be indicative of above average returns over the following few months. Low valuations, in contrast, have a tendency to be indicative of strong returns over a longer period and with low correlation to momentum. Both factors have periods of outperformance and underperformance that often occur at different times. By combining both, I am trying to create a strategy with fewer periods of underperformance than either of the two alone.
Below, I've applied one variation of this strategy to the ten major stock market sectors. For macro investors, sector ETFs are an easy choice to gain exposure to the top sectors, while for investors who pick individual stocks, the top sectors are a good starting place to look.
To measure valuations of each sector, I used the median Earnings Yield, P/S, P/B and PEG ratio. While this method is not perfect as some sectors' valuation metrics tend to revert to different levels, it can still give us a good idea about where valuations are.
For comparing momentum, I used the sum of the price performance over the last 13, 26, and 52 weeks of each sector and also of an equal weighted sector index. Using two indexes with different weighting methods can give us a better idea of sector momentum than one index alone.
To blend the signals from the valuation metrics and momentum metrics, the sectors were sorted by each of the metrics and given a score based on their position. The scores of each metric were then added up and this result was ranked according to the result. The valuation metrics together were given a 50% weighting and the momentum metrics were given the other 50%.
The top two sectors, energy and industrials, don't have great valuations, but their momentum is strong. On the other hand, the third sector, consumer discretionary, has low valuations, but its momentum isn't so good.
Within the energy sector, I like ConocoPhilips (NYSE:COP) and Marathon Oil (NYSE:MRO). Both have low valuations and strong momentum as well as a 2%+ stable dividend.
In the industrial sector one company with strong fundamentals is General Dynamics (NYSE:GD). General Dynamics trades at less than 12 times trailing earnings at the same time as having stable profit margins. In addition, it has a rising dividend which currently yields 2.17%.
One stock to consider in the consumer discretionary sector is Ross Stores (NASDAQ:ROST). I wrote a bullish analysis of it a few weeks ago, and since then it has outperformed by almost 6%. Even with the rise, I still like Ross Stores, although not quite as much.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.