Sector Detector: Energy Leads A 'Toppy' Stock Market

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Includes: AGG, IDU, IYC, IYE, IYH, IYK, IYR, IYW, IYZ, SPY, TBT, TLT, XLF
by: Scott Martindale

Stocks are finding that psychological barriers at Dow 13,000 and Nasdaq 3,000 will require broader participation to eclipse. Although both the Dow and Nasdaq have exceeded and held above their 2011 highs, the S&P 500 is having difficulty surpassing its 2011 highs near 1370. And the “riskier” indexes like the Russell 2000 small caps, the S&P 400 mid caps, and the MSCI emerging markets indexes all have quite a lot of work to do to even approach their 2011 highs.

Among the 10 U.S. sector iShares, Energy (NYSEARCA:IYE) has been the winner this week as oil prices have skyrocketed. In fact, prices at the gas pump have become the new all-consuming topic of the day impacting everyone’s pocketbook, and causing worry about its impact on economic recovery. Over the weekend, Iran announced that it would stop selling oil to Great Britain and France in response to a planned European oil embargo this summer. As a result, West Texas Intermediate crude (WTI) rose by $2.65 to close Wednesday at $106.35/barrel, which is the highest price for WTI since May 2011 and a record high for this time of the year. So, it’s no surprise that energy stocks have been the market leaders.

Of course, the other perennial leader is Apple Inc. (NASDAQ:AAPL). Hulu might joke in its commercials that it is striving to take over the world, but Apple actually appears to be doing it. $500 is now in its rearview mirror as it marches onward toward global domination.

On Tuesday, the EU announced a deal to “rescue” Greece, thus averting a March debt default. However, they had to agree to more cuts in pensions, wages, and public employee jobs, plus healthcare and defense spending. Even before these cuts, Greece has 20% unemployment, and 40% among its younger workers. And of course, such measures will further erode consumer sentiment and economic activity in Greece. And don’t forget that their creditors have to absorb a $100 billion hit, too. Nevertheless, bond yields in Spain and Italy have dropped in response, as investors gain confidence that there is sufficient conviction to bolster the other struggling eurozone nations.

Although the U.S. economy and unemployment levels are improving, it’s safe to say that the average American is still on a tight budget. And because consumer spending drives corporate earnings growth, Factset Research reports that only 63% of the S&P 500 companies beat earnings estimates this past quarter, and even worse, only 43% beat revenue expectations. So cost-cutting seems to be the driver to meeting earnings estimates.

IndexUniverse reports that ETF funds have been flowing out of U.S. Equity and into International Equity and U.S. Fixed Income, possibly indicating a flight to safety in advance of a market pullback. SPY has lost the bulk of those funds to the tune of about $870 million, and to a lesser extent the XLF and TBT (UltraShort Treasuries) have seen large outflows. Gaining some of those dollars, at least for the moment, has been IYR (iShares Real Estate) and bond funds like TLT and AGG.

Real estate has been getting some investor interest lately as improving reports on housing sales and low mortgage rates have been in the news. Nevertheless, Sabrient’s forward-looking SectorCast-ETF model gives IYR a “Least Attractive” rating and an Outlook score of only 8. On Wednesday, the news wasn’t so promising as existing home sales for January missed expectations and there was a significant downward revision to the prior month sales.

Looking at the charts, SPY continues to be incredibly resiliency as bulls just won’t give up much ground. The overbought technicals have refused to cycle back down. But nothing goes up forever, and RSI, MACD, and Slow Stochastic are all threatening to roll over.

Last week I showed a comparison of the current rally that started at the beginning of October 2011 versus the prior year’s rally that started a bit earlier—at the beginning of September 2010—and basically peaked around late February. The past week has done nothing to dissuade that comparison, and I still expect a test of support at the uptrend line, which now meets up with the 50-day simple moving average around 130.

The oscillators are overdue to cycle back down, and it can be a self-fulfilling prophecy as more and more technicians call for it. On the other hand, the market usually likes to confound the greatest number of people, so it might try to suck in a few more latecomers before its next pullback.

Today, I came across the McClellan Summation Index, which is an intermediate-term market breadth indicator derived from the McClellan Oscillator, based on net advances (advancing issues less declining issues). It is currently at an extreme high and threatening to turn down, which generally increases the odds of a market correction.

The VIX (CBOE Market Volatility Index—a.k.a. “fear gauge”) closed Wednesday at 18.19, which is back below the 20 threshold. It briefly moved back above 20 last week, but it only closed the trading day above it on one day (Wednesday) as it was repelled by resistance at its 50-day simple moving average. However, although the VIX is indicating investor complacency and confidence at the moment, portfolio managers who trade volatility as a separate asset class look beyond the spot VIX and into the VIX futures to see what’s going on with longer-term investor sentiment. Looking further out on the VIX term structure, there is actually quite a bit of anxiety about where stocks will be a year from now.

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) continues to retreat. It continues to drop and closed Wednesday at 41 bps after briefly dropping below 40 last week. The trend change from its recent highs near 60 reflects improving investor confidence—although it is still well above the teens we saw early last year.

Volume remains light, and a real breakout attempt likely will need broader participation to get follow-through. I expect a pullback to begin either now or after a false breakout attempt. Either way, I don’t see the market maintaining much in the way of further gains until it consolidates existing gains more effectively. Nevertheless, investors are being pushed toward stocks as the Fed and ECB continue to flood the world with fiat currency, making other investments look much less desirable in comparison.

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 Sabrient’s 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 (NYSEARCA:IYW) remains at the top of the Outlook rankings with a robust 88. 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. Healthcare (NYSEARCA:IYH) retains the second spot, with a bit more distance past third place Industrial (BATS:IYJ). IYJ enjoys better growth projections, while IYH displays more compelling valuations.

3. Consumer Services (NYSEARCA:IYC) is making a gradual but notable move higher in the Outlook rankings, buoyed primarily but a strong analyst sentiment score.

4. Telecom (BATS:IYZ) still dwells at the bottom of the rankings with a weak score of 1. IYZ remains saddled with the worst return ratios, lack of analyst support, and one of the highest projected P/Es. It is again joined in the bottom two by Utilities (NYSEARCA:IDU) with a score of 23. IDU has poor long-term growth projections and relatively high projected P/E. In fact, the bottom three now also includes Consumer Goods (NYSEARCA:IYK), so seeing these three traditionally defensive sectors all at the bottom is a bullish sign for market direction.

5. Looking at the Bull scores, IYM has been the leader on strong market days, scoring 55, followed by IYF and IYJ at 54. Utilities (IDU) is by far the weakest on strong days, scoring a meager 34.

6. As for the Bear scores, IDU is the investor favorite “safe haven” on weak market days, with a score of 58, which continues to fall, followed by IYH at 57. IYF and IYM now display the lowest Bear score of 47, which means that stocks within these ETFs sell off the most on weak market days.

7. Overall, IYW still shows the best combination of Outlook/Bull/Bear scores. Adding up the three scores gives a total of 190. IYZ is the worst at 100. IYJ shows the best combination of Bull/Bear with a total score of 103, while IDU has the worst combination at 92, as the “risk on” trade prefers alternatives to defensive-oriented Utilities, Telecom, and Consumer Goods stocks.

Top ranked stocks in Technology and Healthcare include F5 Networks (NASDAQ:FFIV), Apple Inc. (AAPL), Triple-S Management (NYSE:GTS), and Jazz Pharmaceuticals (NASDAQ:JAZZ).

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.

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 sector.

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.