Sector ETF Rankings: Weekly Update for May 15, 2011

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Includes: XLB, XLE, XLF, XLI, XLK, XLY
by: Diffusion

Please read “ETF Ranking: A New Fundamental Approach That Drives Short-Term Return" for a brief understanding of our methodology for sector ETF rankings.

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.

ETF

Rank as of 5/14/11

Rank as of 5/7/11

XLE

67.54

67.37

XLB

65.04

67.95

XLK

60.69

61.38

XLI

48.28

50.43

XLY

40.14

45.10

XLF

23.75

20.75

XLE and XLB interchanged their positions again last week.

Price change affects valuation, thus rank changes when price changes. Besides, rank changes when new fundamental numbers enter the ranking system, which is normal in an earnings season. Last week, the price of XLB saw a larger drop than that of XLE. All else being equal, XLB’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 materials sector during earnings season.

Let’s reevaluate the long XLB / short XLF recommendation we made last week. Its expected return is proportional to the spread between the ranks of XLB and XLF. The spread is at 65 - 24 = 41, six points below that of the week before, which was at 68 - 21 = 47. A shrinking spread always flashes a yellow light because the expected return diminishes. Additionally, we would like to caution that the spread may shrink more if the fundamentals of the materials sector further deteriorate. Therefore, we will switch from XLB to XLE in the coming week.

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. Although the ranks appeared to be volatile lately, we believe we will see less fluctuation after earnings season.
  • Bearish: Short XLF, the one with the lowest rank.
  • Neutral: Long XLE and short XLF for the same dollar amount.

We pick the last one mainly due to our neutral market view. As mentioned before, spread is an important factor for this plan. At 68 - 24 = 44, the spread is fairly large. Because 10 rank points translated to 1.7% annualized return, our expected annualized return is 1.7% x 44 / 10 = 7.5%. It is noteworthy that this number is derived from the past 10 years. The S&P 500 returned merely an annualized 2.5% in that period. A 7.5% return is really three times the market return. That said, historical returns do not guarantee future performance.

Still, it is a warning sign that the spread between XLE and XLF shrank last week. The spread was at 67 - 21 = 46 the week before. Two rank points are not statistically significant. Nonetheless, investors want to pay close attention to the spread down the road.

Appendix: Please see the "Between Fundamental and Short Term Returns" section in our methodology article (linked above).

Disclosure: I am long XLE. I'm also short XLF.