Sector Detector: Awaiting The Next Catalyst

|
 |  Includes: IYC, IYE, IYF, IYJ, IYK, IYM, IYW, IYZ, SPY
by: Scott Martindale

After last week's technical breakout on elevated volume, stocks have flattened and trading volume has waned as investors seem to be waiting to see whether there will be a pullback to test new support levels and the bulls' conviction. I think the bulls are plenty convicted - not conflicted.

New round-number resistance-turned-support levels are at 13,000 on the Dow, 3,000 on the Nasdaq, and 1400 on the S&P 500. The S&P was the last to breakout and the first to test support. In fact, it has been testing support at 1400 every day since it broke out last Thursday. So far this week, there has been little movement in any asset class as investors hold their positions and wait for the next catalyst. Gold, oil, and the U.S. dollar are all slightly down, 20-year Treasuries are slightly up, and stocks and the U.S. dollar are mostly flat. But the fact remains that there is little incentive to invest in low-yielding Treasuries right now.

Among the ten U.S. sector iShares, Consumer Goods (NYSEARCA:IYC) has been the strongest this week through Wednesday, up about +1%, followed by Technology (NYSEARCA:IYW), Telecom (NYSEARCA:IYZ), and Consumer Goods (NYSEARCA:IYK), while Energy (NYSEARCA:IYE) has been the decisive laggard, down about -2%. The big leader of last week's technical breakout was the Financial sector, and IYF still displays the best overall performance since then.

With banks standing on firmer footing, the Fed is now allowing those that pass their "stress test" to boost dividends and buy back stock. And they are doing so. Some like Citigroup (NYSE:C) and Sun Trust Bank (NYSE:STI) have not yet passed the test, but others like Bank of America (NYSE:BAC), Wells Fargo (NYSE:WFC), U.S. Bancorp (NYSE:USB), and JP Morgan (NYSE:JPM) are getting aggressive.

Again, I just can't help but say something about Apple Inc. (NASDAQ:AAPL) this week. It was just two months ago that I was talking about AAPL finally pulling back into a tie with Exxon Mobil (NYSE:XOM) in the largest-market-cap sweepstakes. Now the comparison is a distant memory as XOM has stayed flat at a little over $400 billion while Apple has soared 35% in two months to reach a market cap of over $560 billion.

As I pointed out last week, the "junk rally" phase we have been in might be foretelling an imminent pullback to "re-rationalize," if you will. Higher quality stocks have been underperforming those that were beaten down or have high short interest. But quality will inevitably rise again.

Looking at the SPY chart, it closed Wednesday at 140.21. Last week, it blasted through resistance at 140 for the first time since mid-2008. It now finds itself right in the middle of its up-sloping channel that has been forming since late-December, with resistance around 142 and near-term support around 138. Below that, there is support from the longer-term uptrend line around 135, which also coincides with the rising 50-day simple moving average.

Click to enlarge

RSI, MACD, and Slow Stochastic are all pointed as if they want to cycle back down to oversold territory. But bulls might insist on churning in place to work off the short-term overbought conditions rather than pull back with any significance. Eventually, price will test its 50DMA for support, but it doesn't have to happen anytime soon.

The VIX (CBOE Market Volatility Index - a.k.a. "fear gauge") closed Wednesday at 15.13, which is just about exactly where it was last Wednesday, and it is comfortably below the important 20 threshold. In fact, it has remained in a range of 14-16 since the Dow and Nasdaq breakouts last Tuesday. 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 39 bps, where it has held since mid-February after falling rapidly from near 60 at the beginning of the year. For now, this appears to be the level or credit risk at which investors are comfortable.

Yes, investors seem comfortable with the prospects for stocks and the economy right now. The biggest things that could throw investors into a tizzy are the usual: a sovereign debt default in Europe, a slowdown in China's growth, or war in the Middle East (and the associated pinch in oil supplies). But the ECB seems willing to provide all liquidity necessary to prevent a default in Europe, the Chinese government stands ready with its stimulus machinery if necessary (and India's industrial production is humming along), and Saudi Arabia is pledging to make up the difference in any world oil supply shortfall.

The Fed's monetary policy appears to be keeping the U.S. economy afloat for now with lots of cheap cash. The next earnings season, which kicks off in mid-April, will tell a lot about corporate earnings impacts. If the market can maintain its low volatility by working off overbought technicals and absorbing the occasional bad news without giving back much in price, cash on the sidelines should continue to come into the market and support the bulls.

Latest rankings: The table ranks each of the ten U.S. industrial sector iShares (ETFs) by our 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 an 81. IYW is particularly strong in its return ratios as margins remain high in tech products. It is also relatively strong in its long-term growth rate and in analyst positive sentiment.

2. Healthcare (NYSEARCA:IYH) moves up into a tie with Financial (NYSEARCA:IYF) for second place with a score of 64. Financial and Consumer Services (IYC) stocks are getting the most support from Wall Street analysts. With the big rally in Financials, the sector no longer reflects the lowest projected P/E, which has resulted in a lower Outlook score.

3. Energy (IYE) and Materials (NYSEARCA:IYM) have been beaten down and now reflect the lowest projected P/Es. IYM continues to get net earnings downgrades from the analysts.

4. Telecom (IYZ) remains at the bottom of the rankings with a 2. 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 20. IDU has poor long-term growth projections and relatively high projected P/E.

5. Looking at the Bull scores, Financial (IYF), Industrial (NYSEARCA:IYJ), and Materials (IYM) are tied for the lead on strong market days, scoring 54. These three are the only ones scoring above 50. Utilities (IDU) is by far the weakest on strong days, scoring 35.

6. As for the Bear scores, IDU is the investor favorite "safe haven" on weak market days, scoring 56, followed by IYW and IYH at 54. IYM shows by far the lowest Bear score of 40. This means that Basic Materials stocks tend to sell off the most when the market is pulling back (which hasn't been happening very often).

7. Overall, IYW still shows the best combination of Outlook/Bull/Bear scores. Adding up the three scores gives a total of 183. IYZ is by far the worst at 97. IYW also shows the best combination of Bull/Bear with a total score of 102. IDU now has the worst combination at 91, with IYE close by at 92.

These scores represent the view that the Technology and Healthcare sectors may be relatively undervalued overall, while Utilities and Telecom sectors may be relatively overvalued based on our 1-3 month forward look.

Top ranked stocks within Technology and Healthcare sectors include VMware (NYSE:VMW), TIBCO Software (NASDAQ:TIBX), Halozyme Therapeutics (NASDAQ:HALO), and DUSA Pharmaceuticals (NASDAQ:DUSA).

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

About SectorCast: Rankings are based on Sabrient's SectorCast model, which builds a composite profile of each equity ETF based on bottom-up scoring of the constituent stocks. The Outlook Score employs a fundamentals-based multi-factor approach considering forward valuation, earnings growth prospects, Wall Street analysts' consensus revisions, accounting practices, and various return ratios. It has tested to be highly predictive for identifying the best (most undervalued) and worst (most overvalued) sectors, with a one-month forward look.

Bull Score and Bear Score are based on the price behavior of the underlying stocks on particularly strong and weak days during the prior 40 market days. They reflect investor sentiment toward the stocks (on a relative basis) as either aggressive plays or safe havens. So, a 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.

Thus, ETFs with high Bull scores generally perform better when the market is hot, ETFs with high Bear scores generally perform better when the market is weak, and ETFs with high Outlook scores generally perform well over time in various market conditions.

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 ten iShares ETFs representing the major U.S. business sectors.

About Trading Strategies: There are various ways to trade these rankings. First, you might run a sector rotation strategy in which you buy long the top 2-4 ETFs from SectorCast-ETF, rebalancing either on a fixed schedule (e.g., monthly or quarterly) or when the rankings change significantly. Another alternative is to enhance a position in the SPDR Trust exchange-traded fund (NYSEARCA:SPY) depending upon your market bias. If you are bullish on the broad market, you can go long the SPY and enhance it with additional long positions in the 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 prefer not to bet on market direction, you could try a market-neutral, long/short trade-that is, go long (or buy call options on) the top-ranked ETFs and short (or buy put options on) 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.