Sector Detector: Bernanke's Words Can't Override His Actions

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Includes: ATHN, BIDU, DFS, IYC, IYF, IYW, PRU
by: Scott Martindale

It comes as no surprise that stocks are struggling to break through technical barriers at Dow 13,000, Nasdaq 3,000, and S&P 500 1370. I continue to believe that it will require greater market breadth and trading volume to achieve a major breakout. Even though Fed Chairman Bernanke on Wednesday threw a wet blanket on the bullish flame by playing down economic recovery while giving no hints about further quantitative easing in his semiannual testimony to Congress, the market still wouldn’t sell off much. Apparently, his cautious words can’t override his stimulative actions.

Among the 10 U.S. sector iShares, Technology (NYSEARCA:IYW), Financials (NYSEARCA:IYF), and Consumer Services (NYSEARCA:IYC) have been the leaders this week. No surprise about IYW given that high-flying Apple Inc. (NASDAQ:AAPL) makes up 18% of the ETF. As it turns out, IYW and IYF are also the top ranked sector ETFs in this week’s Sabrient rankings.

It’s a nice change of pace to not see European sovereign debt as the top headline lately. Although avoiding a Greece debt default is still not a certainty (or even a high probability), there are definite signs of stability in the eurozone—at least for the moment. Bond rates in Italy and Spain are below “critical” levels.

Still, austerity requirements from its rescuers have plunged Greece into a deep recession. The Greek economy contracted by 7% during 4Q2011 and unemployment is about 20% (46% among the younger workers). And there is a lot of doubt throughout the international community that Greece has the will to pull it off in the face of violent anti-austerity protests. Spreads on Greek 5-year Credit Default Swaps have risen such that the market has essentially priced in a Greek default. The market would next watch for a possible contagion spreading to Italy, Spain, Portugal and Ireland. Furthermore, S&P cut its outlook on the European Financial Stability Facility (EFSF) to negative. Nothing is coming easy in solving this crisis.

But here in the U.S., near-term signs continue to brighten. Despite the steep rise in the major averages, valuations are still reasonable on a historic basis. The forward (i.e., using next year’s consensus earnings estimates) price-to-earnings ratio (P/E) for the S&P 500 is about 13x. This contrast favorably with the historic average of 15x over the past 10 years.

Of course, the forward P/E comes with uncertainty. If we instead look at the trailing 12-month (TTM) P/E, the S&P 500 is closer to 14x. For comparison, when the S&P 500 was at this same price level last May, its valuation was closer to 16x, and in summer 2008, its valuation was more like 17x. So, current S&P 500 valuation is reasonable, and even more so given that other liquid investment alternatives like bonds have been rendered relatively unattractive, courtesy of the Fed’s low-interest rate, weak-dollar (a.k.a., “stimulative”) policy.

However, Jonathan Golub, chief U.S. equity strategist for UBS, has recently stated that without the incredible earnings contribution from Apple, U.S. corporate earnings average growth is only about 2%, which isn’t quite so encouraging. Indeed, Wall Street analysts on balance have been cutting back on their earnings estimates.

Since the turn of the century, the S&P 500 has gone up a little and down a lot, and today it is essentially right back where it started, leading many observers to say that you can’t buy-and-hold stocks anymore. Instead, they say you must trade the “trading range”—and current valuations are closer to the high end than the low end. There is some validity to that argument if you only trade the indexes, but that doesn’t mean you can’t own the very best stocks for the long haul.

Certainly, Apple (AAPL) is one for the ages. The stock is up 34% this year (through Wednesday) and 4,500% over the past 10 years. It is now valued at over half a trillion dollars, making it by far the largest market cap company in the world—leaving Exxon Mobil (NYSE:XOM) in the dust. But even after such a huge rise, it is still trading only around 11x forward earnings, which is quite reasonable for such a fast-growing juggernaut. Much of its recent strength has been in anticipation of next week’s expected unveiling of the new iPad 3, which rumor has it may be offered in three versions: Wi-Fi, 3G, and the long-awaited 4G. Ay, caramba!

Other stocks have stood out, as well. Since the Dow was last above 13,000 in May 2008, big winners from that index include McDonald’s (NYSE:MCD), Home Depot (NYSE:HD), IBM (NYSE:IBM), and Caterpillar (NYSE:CAT). Caterpillar, the world’s largest maker of earth-moving equipment, expects U.S. construction spending will increase in 2012 for the first time since 2004. Perhaps U.S. manufacturing is coming back. On the losing side, poor perfomers since May 2008 include Bank of America (NYSE:BAC), Alcoa (NYSE:AA), Hewlett-Packard (NYSE:HPQ), and General Electric (NYSE:GE). Clearly good stock picking in long-term investments can work, even if the major averages tread water.

As further examples, our “Baker’s Dozen” Top Stocks for 2012 are doing quite well so far this year, led by strength in Seagate Technology (NASDAQ:STX), Western Refining (NYSE:WNR), United Rentals (NYSE:URI), Kronos Worldwide (NYSE:KRO), and Dana Holdings (NYSE:DAN). On the short side, Sabrient subsidiary Gradient Analytics focuses on identifying “at risk” stocks from a forensic accounting and earnings quality perspective. Several stocks having negative grades were quite weak on Wednesday, including TeleTech Holdings (NASDAQ:TTEC), Universal Display (NASDAQ:PANL), First Solar (NASDAQ:FSLR), SodaStream International (NASDAQ:SODA), Magellan Health Services (NASDAQ:MGLN), and Gentex (NASDAQ:GNTX). Again, judicious stock picking—both long and short—can help an investor win in any market environment.

Looking at the charts, the overbought technicals persist. With low volatility, they can stay like this for a long time, but eventually they will make a return visit to oversold territory. After breaking through resistance from its 2011 highs near 137 on Tuesday, SPY settled Wednesday right at that level. Last week I said that I expected either an immediate pullback or a “false breakout” to suck in a few more bulls before falling. We might be in the process of the latter. Notice in the chart that in addition to the 5-month uptrend line, I also show another uptrend line that started at the beginning of the year. It forms a tight channel with the upper Bollinger Band. Note also that the upper and lower Bollinger Bands have settled into a tight channel of their own. A breakdown through the near-term uptrend line will likely lead to an overdue test of support at the longer term uptrend line, and allow the Bollinger Bands to widen again and the oscillators to cycle back down. This would be healthy for a renewed bull run.

For the past two weeks, I have talked about how the current rally that started at the beginning of October 2011 compares with the prior year’s rally that peaked around late February 2011. As we have now reached the end of February 2012, I expect a similar breakdown and pullback that tests support at the uptrend line, which now sits near 131.

The VIX (CBOE Market Volatility Index—a.k.a. “fear gauge”) closed Wednesday at 18.43, which remains below the important 20 threshold and reflects investor confidence and complacency. 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 44 bps after making a couple of recent trips below 40. The trend change from its highs near 60 reflects improving investor confidence—although it is still well above the teens we saw early last year.

Volume remains light, although it was elevated a bit on Wednesday. I still believe that any real breakout attempt likely will need broader participation to get follow-through. There remains a lot of cash on the sidelines, and many fund managers are under-invested and looking for an opportunity to get in.

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 our 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.

Observations:

1. Technology (IYW) remains at the top of the Outlook rankings with a 85. IYW is particularly strong in its return ratios as margins remain high in tech products. It is also relatively strong in analyst positive sentiment—even though analysts have been generally cutting their earnings estimates across the board.

2. The surprise second-place ETF is Financial (IYF), as it rose 10 points to 69 while Industrial (NYSEARCA:IYJ) and Healthcare (NYSEARCA:IYH) fell in the rankings. The big differentiator this week is analyst “Net Revisors,” as Financial stocks got a lot of support compared with the other sectors.

3. Telecom (NYSEARCA:IYZ) still dwells at the bottom of the rankings, but renewed analyst support has given it a more respectable score of 20 this week. IYZ remains saddled with the worst return ratios and one of the highest projected P/Es. It is again joined in the bottom two by Utilities (NYSEARCA:IDU) with a score of 22. IDU has poor long-term growth projections and relatively high projected P/E.

4. Looking at the Bull scores, IYM has been the leader on strong market days, scoring 54, followed by IYF and IYJ at 52. Utilities (IDU) is by far the weakest on strong days, scoring a meager 29.

5. As for the Bear scores, there are a lot of surprising changes this week. IDU is no longer the investor favorite “safe haven” on weak market days. Technology (IYW) is tops at 53 followed by IYH at 52, while IDU falls to 49. IYF and IYM display the lowest Bear score of 42, which means that stocks within these ETFs sell off the most on weak market days.

6. Overall, IYW still shows the best combination of Outlook/Bull/Bear scores. Adding up the three scores gives a total of 183. IDU is the worst at 100. IYW also shows the best combination of Bull/Bear with a total score of 98, while IDU has the worst combination at 78, as the “risk on” trade prefers alternatives to defensive-oriented Utilities, Telecom, and Consumer Goods stocks.

Top ranked stocks in Technology and Financial include Baidu (NASDAQ:BIDU), athenahealth, Inc. (NASDAQ:ATHN), Prudential (NYSE:PRU), and Discover Financial Services (NYSE:DFS).

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.

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