Financials are oversold by some standard, but fundamentals say stay short.
Notwithstanding a brief bounce last Thursday, the Financial Select Sector SPDR ETF (XLF) sits on the lower bound of Bollinger Band eight days in a row. Technical analysis textbooks say it indicates a severe oversold condition and rebound is just around the corner.
However we still recommend staying short with XLF according to its grim fundamentals. The short position is used as portfolio protection when uncertainty is looming. Indeed, in the past four weeks we have consecutively recommended pairing the short position of financials with a long position on energy. The pair has gained a combined 5.5% in the period.
We consulted our ETF ranking system to gain insight into which sector is likely to outperform and which sector is likely to underperform. The ranking system is based on valuation, financial condition, and return on capital and has predictive power. For a brief understanding of our methodology, please read “ETF Ranking: A New Fundamental Approach That Drives Short-Term Return."
Our ETF ranking system indicated that financials’ fundamentals deteriorated last week. This is the main reason for our recommendation. Personally we believe that technical reflects fundamental. If fundamentals remain bleak, we are comfortable staying short even if it is oversold.
Action Plan for the Week
We list this week’s ranks of offensive sector ETFs in the table below, together with last week’s ranks.
Rank as of 6/11/11
Rank as of 6/4/11
XLE holds its top position in the past week. XLF holds its bottom position as well.
Let’s reevaluate the long XLE / short XLF recommendation we made last week. Its expected return is proportional to the spread between the ranks of XLE and XLF. The spread is at 67.6 – 20.9 = 46.7, about three points higher than that of the week before, which was at 68.3 – 24.3 = 44.0. An expansion of three points is fairly large compared to previous weeks. The development is encouraging because the expected return grows in proportion.
Remember the ranking system is based on valuation, financial condition, and return on capital. Price change affects valuation, thus rank changes when the price changes. Besides, rank also changes when new fundamental numbers enter the ranking system. Last week, the price of XLF saw a larger drop. All else being equal, XLF’s valuation should be better so its rank should rise, contrary to what we saw last week. This is alarming because it indicates that we were seeing bad fundamental numbers in the financials sector last week.
In our opinion, XLF saw a big drop because investors were concerned by the deterioration of its fundamentals. Barring any fundamental changes, staying short on XLF is likely to profit from its weakness.
It should be noted that although the ranking system is designed for short-term return, the best strategy for investors is to follow it continuously and allow profit to accumulate. It is not for gamblers who hope to make a big hit and take money off the table right after it. This mindset will make gamblers second-guess a short position in face of a severe oversold condition.
Depending on a trader’s market view, we recommend three trading plans:
- Bullish: Long XLE, the one with the highest rank. Although the ranking system is designed for a one week return, traders may hold it for four to six weeks because the ranks of ETFs change slowly.
- Bearish: Short XLF, the one with the lowest rank.
- Neutral: Long XLE and short XLF for the same dollar amount.
We picked the last one mainly due to our neutral market view. As mentioned before, spread is an important factor for this plan. At 46.7, the spread is fairly large. Because 10 rank points translated to 1.7% annualized return, our expected annualized return is 1.7% x 46.7 / 10 = 7.9%. It is noteworthy that this number is derived from the past 10 years. The S&P 500 (SPY) returned merely an annualized 2.5% in that period. A 7.9% return is really more than three times the market return. That said, historical returns do not guarantee future performance.
It is healthy that the spread between XLE and XLF expanded last week. Because the spread is proportional to the expected return, any shrink would be a warning sign.
Appendix: Please see the "Between Fundamental and Short Term Returns" section in our methodology article (linked above).