Sector Detector: Expecting Continued Strength in InfoTech, Weakness in Materials

Includes: IYW, IYZ, XLB, XLV
by: Scott Martindale

Although Sabrient’s SectorCast-ETF rankings have not changed dramatically, there are some definite signs of a more conservative bent evolving. And there seems to be good reason for it. After carefully scaling the proverbial wall of worry last week, this week saw the market lose the important technical support levels that it had fought so hard to reclaim.

The market continues to search for direction. Last week, the S&P 500 and Dow Jones Industrials joined the Nasdaq 100 and Russell 2000 by rising above the important 200-day moving average, and they all appeared to be ready to eclipse their 50-day moving averages (in fact, the Nasdaq 100 did so on Monday’s open). But things have since fallen apart this week, as strong opens have led to weak closes, and each of their 200-day MAs have given way yet again.

There’s no doubt that Tuesday’s weak close was a big disappointment to the bulls. We’ll see if they decide to abandon the market or find a reason to inject renewed support. Perhaps the Nasdaq and small caps will hold their 200-day MA and save the market.

Notably, cash on hand among the S&P 500 companies are now at record levels, and up 25% over the same time last year. Perhaps these firms will soon support the market through share buybacks, M&A, or dividend increases – all of which would impact the market favorably.

The SectorCast-ETF model employs a fundamentals-based multi-factor approach including forward valuation, earnings growth prospects, recent analyst consensus sentiment, and various return ratios. Like the technical picture, current quant rankings reflect an uncertain outlook, and in fact they have gotten a bit more conservative.

Latest rankings: Information Technology (NYSEARCA:IYW) retains its lock on the top ranking with a score that holds right at 71 yet again. Whether the market is bullish, bearish, or confused, we consistently have been finding IYW at the top by a healthy margin.

However, the second place spot has been moving around quite a bit among XLE, XLF, and XLV. This week, Healthcare (NYSEARCA:XLV) has returned to the second spot, but this time with a solid 4 point lead over third place Energy (NYSEARCA:XLE).

IYW fares the best in the percentage of analysts increasing earnings estimates, and it ranks high in return on equity, return on sales, and projected year-over-year change in earnings. XLV scores admirably across the board, but is especially strong in return on equity and projected price/earnings ratio.

Top-ranked stocks within IYW and XLV include Corning (NYSE:GLW), Synaptics (NASDAQ:SYNA), Humana (NYSE:HUM) and WellPoint (WLP).

The main driver in score changes this week was the the percentage of analysts increasing earnings estimates, or in this case, reducing estimates. Financials (NYSEARCA:XLF) took the biggest hit on this metric, and its overall score dropped 7 points, from 65 to 58 – knocking it out of the long/short model portfolio. Materials (NYSEARCA:XLB) and Consumer Discretionary (NYSEARCA:XLY) also got knocked back on this metric. Like last week, these two sectors continue to weaken such that long-time weakling Consumer Staples (NYSEARCA:XLP) has now vaulted over both of these sectors, which relegates Materials (XLB) to ninth place with a score of 46, joining Telecommunications (BATS:IYZ) in the short portfolio.

IYZ continues in the cellar with a score of 38. It is weak in almost all metrics, particularly projected year-over-year change in earnings across the stocks in the sector, projected P/E, return on equity, and the percentage of analysts increasing earnings estimates.

The spread between the top and bottom sector scores remains in the mid-30’s, which is tighter than the mid-60’s we were seeing earlier in the year. I prefer to see wider top-bottom spreads to provide added confidence in the relative rankings.

Low-ranked stocks within IYZ and XLB include PAETEC (NASDAQ:PAET), Sprint Nextel (NYSE:S), Allegheny Technologies (NYSE:ATI), and Vulcan Materials (NYSE:VMC).

These scores represent the view that InfoTech and Healthcare stocks may be relatively undervalued overall, while Telecom and Materials stocks may be overvalued.

Performance: I have tracked the performance of each of the prior four weekly portfolios as of the market close on Tuesday, 6/22/2010. Each portfolio assumes that the top two ETFs are entered long and the bottom two are entered short, all at the opening prices on Wednesday. Of course, for those who prefer not to sell short, this could be run as a sector rotation strategy – with perhaps the top 3 or 4 sector ETFs long.

The market has weakened considerably this week, but our top-ranked sector ETF has been consistently outperforming the SPY in both up and down markets. Last week’s portfolio in particular is doing what an absolute return strategy is designed to do. It is up +1.1% while the SPY is down -1.7% over the same 5-day period.

In fact, all four of weekly long/short portfolios are in the black. An absolute return portfolio based on a proven ranking model like SectorCast-ETF is positioned to thrive in a bull market that favors high-quality stocks, while also being prepared for a significant market pullback. In other words, it seeks to capture the performance spread between the top and bottom-ranked sectors, which over time should allow it to profit whether the market goes up or down.

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