Upgrades Boost Raw Materials ETFs

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Includes: CHIM, DBRE, DVYA, EEM, EFA, EGPT, EPOL, FFTY, GULF, IMOM, ITEQ, LVL, PBJ, PICK, PLND, PSCM, PXH, PXI, PYZ, REMX, SLX, SPY, VNM
by: Michael Krause

Summary

Sell-side analysts are an optimistic bunch, but changes in ratings still move markets.

Materials-related ETFs saw the biggest upgrades in Q1, but there's further room to rise.

Emerging markets also saw a surprising upgrade post-election, but not so for frontier markets.

A while back in our blog post Analysts of Lake Wobegon, we noted how sell-side analysts tend to be an optimistic bunch when it comes to their stock recommendations, and that's clearly still the case. Of the more than 9,600 consensus recommendations on single stocks in FactSet's database (our data source), 23% earn the highest "Buy" recommendation, while another 45% enjoy an "Overweight" rating. Impossibly, this means that two-thirds of equities are rated as above average! Meanwhile only 4% are rated "Underweight" or "Sell" (Figure 1).

Most investors understand this imbalance is just a reality of the stock broking business, but that doesn't mean the recommendations are meaningless - far from it. We know that stock prices often respond dramatically to analyst upgrades and downgrades. Further, consensus recommendations - like estimates for sales and EPS - tend to have a momentum of their own (upgrades by some analysts tend to beget upgrades by others, causing the consensus average to trend in one direction for a sustained period). Therefore, it may be worthwhile to examine recent changes in analyst sentiment to see where further upgrades or downgrades may be coming.

Since mid-2015, we have been calculating a consensus recommendation for all the equity ETFs we cover, based on the weighted average of consensus recommendations for each individual constituent. Being an average of an average, broad cap-weighted ETFs like the SPDR S&P 500 (NYSEARCA:SPY) and iShares MSCI EAFE (NYSEARCA:EFA) and iShares Emerging Markets (NYSEARCA:EEM) don't change dramatically from one month to the next, although we can reach a few general conclusions from the histories shown in Figure 2.

Analysts are significantly less enthusiastic about the European and Japanese stocks which dominate the EAFE fund than they are about either U.S. or emerging market equities. In general, analysts became less bullish throughout 2016 as the bull market aged and valuations got richer. There was a significant upgrade to stocks in emerging markets following the U.S. presidential election (surprisingly), which appears to have been sustained.

Figure 1: Distribution of Ratings

Current consensus ratings on equity universe

Figure 2: Consensus Ratings History

SPY, EFA & EEM, June 2015-March 2017

Source: FactSet and ETF Research Center

Source: FactSet and ETF Research Center

Note: Ratings figures based on the following five-tier scale: 1 = Buy; 1.5 = Overweight; 2 = Hold; 2.5 = Underweight; and 3.0 = Sell. Ratings for each ETF are calculated based on a weighted average of consensus ratings for each fund's individual constituents.

However, more narrowly focused funds can often see bigger shifts. We scanned our database to locate ETFs that have seen the biggest upgrades and downgrades during the first three months of the year. A top 10 list for each is shown in the tables below. Keep in mind that under the FactSet system whose data we analyzed, lower numbers are more bullish (details in notes to tables), so a negative number in the change column represents an improvement in the consensus recommendation, and a positive number represents a deterioration.

Among the most improved, the Materials sector figures prominently (Table 1). Even some funds where that might not be obvious at first glance, such as the MomentumShares International Quantitative Momentum ETF (NYSEMKT:IMOM), have considerable exposure. Materials is IMOM's biggest single sector exposure at 30% of the fund.

On the Downgrades side of the ledger (Table 2), the recent strength in emerging markets does not appear to extend to frontier markets like Vietnam, Poland and Egypt - which are tracked by the first four ETFs on the list - as well as markets like UAE, Qatar and Kuwait, found in the WisdomTree Middle East Dividend ETF (NASDAQ:GULF). Notice also a number of foreign yield plays on the list, both dividend-oriented funds as well as real estate. This makes sense if in fact the Federal Reserve continues raising interest rates, in turn making yield plays relatively less attractive. Foreign stocks could also be more vulnerable than domestic dividend plays if rising interest rates continue to push the value of the USD up.

Table 1: Upgrades: ETFs with Most Improvement in Consensus Ratings

First Quarter 2017

Ticker Fund Name Consensus Rating on 12/31/16 Consensus Rating on 3/31/17 Change

CHIM

Global X China Materials

1.62

1.44

-0.18

REMX

VanEck Vectors Rare Earth/Strategic Metals

1.72

1.58

-0.14

PYZ

PowerShares Dynamic Basic Materials Sector

1.71

1.58

-0.13

IMOM

MomentumShares Int'l Quantitative Momentum

1.79

1.67

-0.12

SLX

VanEck Vectors Steel

1.78

1.67

-0.11

PSCM

PowerShares S&P Small Cap Materials

1.74

1.64

-0.10

PXH

PowerShares FTSE-RAFI Emerging Markets

1.71

1.61

-0.10

PXI

PowerShares Dynamic Energy Sector

1.54

1.44

-0.10

FFTY

Innovator IBD 50 Fund

1.46

1.36

-0.10

PICK

iShares MSCI Global Select Metals & Mining

1.75

1.66

-0.09

Note: Ratings figures based on the following five-tier scale: 1 = Buy; 1.5 = Overweight; 2 = Hold; 2.5 = Underweight; and 3.0 = Sell. Ratings for each ETF are calculated based on a weighted average of consensus ratings for each fund's individual constituents.

Source: FactSet and ETF Research Center

Table 2: Downgrades: ETFs with Most Deterioration in Consensus Ratings

First Quarter 2017

Ticker Fund Name Consensus Rating on 12/31/16 Consensus Rating on 3/31/17 Change

VNM

VanEck Vectors Vietnam ETF

1.45

1.65

0.20

EPOL

iShares MSCI Poland Investable

1.97

2.11

0.14

PLND

VanEck Vectors Poland

1.96

2.08

0.12

EGPT

VanEck Vectors Egypt Index

1.37

1.49

0.12

ITEQ

BlueStar TA-BIGITech Israel Technology

1.49

1.61

0.12

DVYA

iShares Asia/Pacific Dividend 30

1.84

1.95

0.11

GULF

WisdomTree Middle East Dividend

1.81

1.90

0.10

LVL

Guggenheim S&P Global Dividend Opportunities

1.73

1.82

0.10

DBRE

Deutsche X-trackers Dow Jones Hedged Int'l Real Estate

1.67

1.76

0.09

PBJ

PowerShares Dynamic Food & Beverage

1.54

1.62

0.08

Note: Ratings figures based on the following five-tier scale: 1 = Buy; 1.5 = Overweight; 2 = Hold; 2.5 = Underweight; and 3.0 = Sell. Ratings for each ETF are calculated based on a weighted average of consensus ratings for each fund's individual constituents.

Source: FactSet and ETF Research Center

Importantly, these upgrades and downgrades do not appear to be an instance of performance-chasing on the part of sell-side analysts. As a group, the Upgrades list underperformed the Downgrades list during Q1, with average returns of 6.0% compared to 9.7%, respectively. Hopefully what the upgrades among Materials stocks reflects is the fact that analysts are seeing a genuine improvement on the ground in terms of fundamentals, perhaps signaling the start of a new commodities cycle. If so, Materials stocks still have considerable room for further upgrades since as a group they rate about in the middle of all sectors (Figure 3).

Figure 3: Consensus Ratings by Sector

On 9,600+ global stocks, as of March 31, 2017

Note: Ratings figures based on the following five-tier scale: 1 = Buy; 1.5 = Overweight; 2 = Hold; 2.5 = Underweight; and 3.0 = Sell. Ratings for each sector are calculated based on a simple average of consensus ratings for stocks in the sector.

Source: FactSet and ETF Research Center

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.