Courtesy of Sabrient Systems and Gradient Analytics
Bulls showed renewed backbone last week and drew a line in the sand for the bears, buying with gusto into weakness as I suggested they would. After all, this was the buying opportunity they had been waiting for. As if on cue, the start of the World Series launched the rapid market reversal and recovery. However, there is little chance that the rally will go straight up. Volatility is back, and I would look for prices to consolidate at this level before making an attempt to go higher. I still question whether the S&P 500 will ultimately achieve a new high before year end.
In this weekly update, I give my view of the current market environment, offer a technical analysis of the S&P 500 chart, review our weekly fundamentals-based SectorCast rankings of the ten U.S. business sectors, and then offer up some actionable trading ideas, including a sector rotation strategy using ETFs and an enhanced version using top-ranked stocks from the top-ranked sectors.
Market overview:
I am in NYC this weekend between trips and visiting my daughter at college, so I’ll keep this short. After some profit protection kicked into gear in the face of an exaggerated Black Swan scare around Ebola, along with all the other usual worries about slowing global growth and terrorism (and the delta-hedge short selling associated with options expiration), investors finally came to their senses. The S&P 500 enjoyed its biggest week of the year (+4.1%), and yet active investment managers (including hedge funds) are now underinvested after dumping shares during the selloff.
As I said in last week’s article, investing is about stacking the odds in your favor, and the more severe technical conditions become, the greater the odds of a bounce or outright reversal. So far, it appears that a classic V-bottom reversal scenario is trying to play out.
But I seriously doubt it will be party time again for the more speculative names. A high-quality balance sheet has become very important. New market psychology has set the stage for lower equity correlations, selective stock picking, and capital flight to the highest quality companies, i.e., those with strong market position, solid cash flow, and low debt levels.
Energy had been by far the worst performing sector for the October (as of mid-month), but the sector got renewed buying interest and has recovered some ground, and at Sabrient we still see lots of attractive valuations among Energy stocks. Reporting this week are heavyweights like Exxon Mobil (XOM), Chevron Texaco (CVX), and ConocoPhillips (COP), so it will be interesting to hear what they have to say and see how investors react. There also is an FOMC meeting and policy statement this week.
Overall, the strong dollar and weak growth in overseas markets means that revenue growth among multinationals will encounter some headwinds, and of course almost half of S&P 500 companies’ sales come from foreign markets. But the strong dollar also is helping keep inflation and interest rates low, which is allowing the Fed to remain accommodative and allowing consumer spending to grow. All in all, stocks stand to benefit. In fact, according to FactSet, with 208 of the S&P 500 companies having reported Q3 earnings so far, the index overall is poised for 5.6% growth versus 4.5% expected.
The CBOE Market Volatility Index (VIX), a.k.a. fear gauge, closed Friday at 16.11. After spiking above 30 earlier in the month (for the first time since November of 2011), it has settled back down but still sits above 15 (which is elevated compared with the persistently low numbers we have seen).
The 10-year U.S. Treasury bond yield closed Friday at 2.28%, which is up slightly from the prior week’s close of 2.2%. After briefly dipping below 2% during the height of the volatility, it has settled back into this comfort zone. I don’t expect any significant rise anytime soon. When you compare this yield to the S&P 500 earnings yield of about 6.6%, the spread is around 4.3% versus the historical norm of about 3%, so there is room for higher equity valuations.
SPY chart review:
The SPDR S&P 500 Trust (SPY) closed Friday at 196.43, which is back above the 200-day simple moving average and challenging the 100-day (and 50-day day close above). In last week’s article I said that the prior week was a disaster from a technical (chart) standpoint. But quite often that can indicate a capitulation selloff, particularly when the fundamental picture is still positive. And so it was. The Dow Industrials held major psychological support at 16k, helping the S&P 500 recapture 1900. Oscillators RSI and MACD are still pointing up bullishly, while Slow Stochastic seems to be hitting a top but still could move higher. Overhead resistance at 190 and the 200-day SMA offered temporary resistance last Monday, but the Tuesday brought a big bullish breakout. Now the 100-day and 50-day SMAs are being tested, and if broken, the $200 price level would serve as the next strong test of resistance, while volume will be a challenge. If price cannot break through the 100-day and 50-day, then the Tuesday gap from 190 will serve as a magnet to be filled and support tested (yet again).
Latest sector rankings:
Relative sector rankings are based on our proprietary SectorCast model, which builds a composite profile of each equity ETF based on bottom-up aggregate scoring of the constituent stocks. The Outlook Score employs a forward-looking, fundamentals-based multifactor algorithm considering forward valuation, historical and projected earnings growth, the dynamics of Wall Street analysts’ consensus earnings estimates and recent revisions (up or down), quality and sustainability of reported earnings (forensic accounting), and various return ratios. It helps us predict relative performance over the next 1-3 months.
In addition, SectorCast computes a Bull Score and Bear Score for each ETF based on recent price behavior of the constituent stocks on particularly strong and weak market days. High Bull score indicates that stocks within the ETF recently have tended toward relative outperformance when the market is strong, while a high Bear score indicates that stocks within the ETF have tended to hold up relatively well (i.e., safe havens) when the market is weak.
Outlook score is forward-looking while Bull and Bear are backward-looking. As a group, these three scores can be helpful for positioning a portfolio for a given set of anticipated market conditions. Of course, each ETF holds a unique portfolio of stocks and position weights, so the sectors represented will score differently depending upon which set of ETFs is used. We use the iShares that represent the ten major U.S. business sectors: Financial (IYF), Technology (IYW), Industrial (IYJ), Healthcare (IYH), Consumer Goods (IYK), Consumer Services (IYC), Energy (IYE), Basic Materials (IYM), Telecommunications (IYZ), and Utilities (IDU). Whereas the Select Sector SPDRs only contain stocks from the S&P 500, I prefer the iShares for their larger universe and broader diversity. Fidelity also offers a group of sector ETFs with an even larger number of constituents in each.
Here are some of my observations on this week’s scores:
1. Technology still holds the top spot with an Outlook score of 88. Although Tech stocks continue to get hit with downward earnings revisions, the sector overall displays the best combination of factor scores in the model, including the strongest return ratios, a good forward long-term growth rate, and a low forward P/E. Healthcare moved back up to the second spot with a 75, primarily because it was the only sector to enjoy significantly positive net upward earnings revisions. Financial is now in third with a score of 64, and it still boasts the lowest (most attractive) forward P/E. Rounding out the top five are Industrial and Consumer Goods. Notably, after making a big 25-point leap in its Outlook score last week, followed by a strong week of performance, Energy’s score fell back 26 points this week as the analyst community has put out a lot more downward revisions (mostly due to lower oil prices).
2. Telecom is back in the bottom spot and continues to score among the worst on most factors in the Outlook model. Basic Materials once again joins it in the bottom two as analysts continue to reduce earnings estimates. Notably, Consumer Services/Discretionary continues to rise in the rankings as analyst support continues to improve to go along with its top-notch forward long-term growth rate.
3. Looking at the Bull scores, Healthcare again displays the highest score of 67, while Utilities is the lowest at 49. The top-bottom spread is now 18 points, reflecting falling sector correlations during particularly strong market days. It is generally desirable in a healthy market to see low correlations and a top-bottom spread of at least 20 points, which indicates that investors have clear preferences in the stocks they want to hold, rather than the all-boats-lifted-in-a-rising-tide (risk-on) mentality that dominated 2013. Also displaying strong Bull scores above 60 are Technology, Industrial, Financial, and Consumer Services/Discretionary, which are all economically-sensitive sectors that should indeed have the highest Bull scores in a healthy market.
4. Looking at the Bear scores, Utilities again displays the highest score of 62 this week, as one would expect for this traditionally defensive sector. Utilities stocks have been the preferred safe havens on weak market days. Energy displays the lowest score of 43. The top-bottom spread is now 19 points, reflecting falling sector correlations on particularly weak market days. Again, it is generally desirable in a healthy market to see low correlations and a top-bottom spread of at least 20 points. Also displaying a strong Bear score is Consumer Goods/Staples (a.k.a., Non-cyclicals), which along with Utilities are traditionally defensive sectors that should have the highest Bear scores in a healthy market. No other sector is close.
5. Technology still displays the best all-around combination of Outlook/Bull/Bear scores, followed closely by Healthcare, while Telecom is the worst. Looking at just the Bull/Bear combination, Healthcare is the leader, followed by Consumer Goods/Staples and Consumer Services/Discretionary, indicating superior relative performance (on average) in extreme market conditions (whether bullish or bearish), while Energy is still the worst, indicating general investor avoidance during extreme conditions.
6. Overall, this week’s fundamentals-based Outlook rankings look even more bullish to me. The top four sectors are all economically-sensitive (or in the case of Healthcare, all-weather), and the top four also display some of the highest Bull scores. Also encouraging is the rise in Industrial and Consumer Services/Discretionary (a.k.a, Cyclicals). Keep in mind, the Outlook Rank does not include timing or momentum factors, but rather is a reflection of the fundamental expectations of individual stocks aggregated by sector.
Stock and ETF Ideas:
Our Sector Rotation model, which appropriately weights Outlook, Bull, and Bear scores in accordance with the overall market’s prevailing trend (bullish, neutral, or bearish), indicates a neutral bias this week, and it suggests holding Technology, Healthcare, and Financial (in that order, for those portfolios that might be due for rebalance on Monday). (Note: In this model, we consider the bias to be neutral from a rules-based trend-following standpoint because SPY is below its 50-day simple moving average but above its 200-day.)
Other highly-ranked ETFs from the Technology, Healthcare, and Financial sectors include Technology Select SPDR Fund (XLK), PowerShares Dynamic BioTech & Genome Portfolio (PBE), and PowerShares KBW Insurance Portfolio (KBWI).
For an enhanced sector portfolio that enlists some top-ranked stocks (instead of ETFs) from within the top-ranked sectors, some long ideas from Technology, Healthcare, and Financial sectors include Western Digital (WDC), Facebook (FB), Regeneron Pharmaceuticals (REGN), Gilead Sciences (GILD), SL Green Realty (SLG), and JP Morgan Chase (JPM). All are highly ranked in the Sabrient Ratings Algorithm and also score within the top two quintiles (lowest accounting-related risk) of our Earnings Quality Rank (a.k.a., EQR), a pure accounting-based risk assessment signal based on the forensic accounting expertise of our subsidiary Gradient Analytics. We have found EQR quite valuable for helping to avoid performance-offsetting meltdowns in our model portfolios.
However, if you think the market will quickly retake its 50-day SMA and you prefer to maintain a bullish bias, the Sector Rotation model suggests holding Healthcare, Technology, and Financial (in that order). And if you prefer a bearish stance on the market, the model suggests holding Utilities, Consumer Goods/Staples, and Healthcare (in that order).
IMPORTANT NOTE: Some readers have been asking for more specifics on how to trade our sector rotation strategy based solely on what I discuss in my weekly newsletter. Thus, I feel compelled to remind you that I post this information each week as a free look inside some of our institutional research and as a source of some trading ideas for your own further investigation. It is not intended to be traded directly as a rules-based strategy in a real money portfolio. I am simply showing what a sector rotation model might suggest if a given portfolio was due for a rebalance, and I may or may not update the information each week. There are many ways for a client to trade such a strategy, including monthly or quarterly rebalancing, perhaps with interim adjustments to the bullish/neutral/bearish bias when warranted — but not necessarily on the days that I happen to post this weekly article. The enhanced strategy seeks higher returns by employing individual stocks (or stock options) that are also highly ranked, but this introduces greater risks and volatility. I do not track performance of the ETF and stock ideas mentioned here as a managed portfolio.
Disclosure: Author has no positions in stocks or ETFs mentioned.
Disclaimer: This newsletter is published solely for informational purposes and is not to be construed as advice or a recommendation to specific individuals. Individuals should take into account their personal financial circumstances in acting on any rankings or stock selections provided by Sabrient. Sabrient makes no representations that the techniques used in its rankings or selections will result in or guarantee profits in trading. Trading involves risk, including possible loss of principal and other losses, and past performance is no indication of future results.
