Defensive Sectors Lead Hesitant Market But Bulls Stand Firm
Scott Martindale | Mar 31, 2015 04:51AM ET
Last week, the major indexes fell back below round-number thresholds that had taken a lot of effort to eclipse. There has been an ongoing ebb-and-flow of capital between risk-on and risk-off, including high sector correlations, which is far from ideal. But at the end of it all, the S&P 500 found itself right back on top of long-standing support and poised for a bounce, and Monday’s action proved yet again that bulls are determined to defend their long-standing uptrend line.
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.
h3 Market overview:/h3Last Thursday, semiconductor stocks took a bath, taking the Philadelphia Semiconductor Index and the overall market down with it, when SanDisk (NASDAQ:SNDK) warned that Q1 revenues could be 10% lower than forecast. The S&P 500 lost the 2,100 level, the Dow Jones Industrials lost the 18,000 level, and the NASDAQ lost 5,000. But bulls stood firm at their line in the sand on Friday, leading to Monday’s powerful rally.
Many are calling this the most hated and manipulated market in history. But hate has helped prevent the irrational exuberance and subsequent bursting bubble of previous markets, including 1987, 2000, and 2007, in which investors were not only fully invested but also heavily margined. Yes, equities are being bought, but the buying is cautious, hesitant. A good bit of high net worth capital is flowing into real estate, private equity, and hedge funds, which is defensive behavior.
Indeed, as we reach the end of Q1, the top performing sector so far this year has been Healthcare by a wide margin, followed by Consumer Services (Discretionary/Cyclical), and then Telecom. As of Monday’s close, the only other sectors that are positive are Consumer Goods (Staples/Noncyclical) and Utilities. Overall, this is a defensive group.
The CBOE Market Volatility Index (VIX), a.k.a. fear gauge, closed Friday at 15.07, which is just barely above the 15 threshold between investor fear and complacency. Nothing onerous here.
The U.S. 10-Year Treasury yield closed Friday at 1.95% and the U.S. dollar continues to trade strong, despite last week’s dip. The latest rounds of quant easing from central banks around the world will continue to push global capital into the U.S. and keep the dollar strong, as well as limit increases in longer-term interest rates. But Fed chairwoman Janet Yellen doesn’t want the dollar to rally too strongly. So it is unlikely that the Fed will hike rates until later in the year, as rising rates would further boost the dollar. The most likely scenario seems to be a token rate increase in September, followed by very slow going from there. Moreover, risk assets such as equities and high-yield debt should continue to attract capital.
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ConvergEx pointed out recently that the yield on the S&P 500 is now the same as the 10-year U.S. Treasury note at just below 2% and that, relatively speaking, this yield is historically high for stocks and low for bonds given that the 10-year Treasury usually yields twice the average dividend yield. Of course, today’s capital markets are quite different than, say, 15 years ago, when the 10-year yielded more than 6% and the S&P 500 traded at a trailing P/E of about 30x and the NASDAQ at 175x, whereas today they are about 18x and 31x, respectively. So, valuations are not too high. Nevertheless, good stock-picking remains paramount.
On that note, as Q1 comes to a close, Sabrient’s Baker’s Dozen annual portfolio of 13 top stocks for the year continues to perform quite well , led by top performers like Tesoro (NYSE:TSO), U.S. Silica (NYSE:SLCA), Valeant Pharmaceuticals (NYSE:VRX), and NXP Semiconductors (NASDAQ:NXPI). Note that NXPI, which is a leader in high performance mixed signals, recently announced the acquisition of Freescale Semiconductor (NYSE:FSL), a leader in embedded processors, which will make the combined company even more dominant in security, near-field communications, and machine-to-machine connectivity.
h3 SPY chart review:/h3The SPDR S&P 500 Trust (ARCA:SPY) closed Friday at 205.74. Once again, for the sixth time in less than four months, it is seeking reliable support from the lower uptrend line of the long-standing bullish rising channel. (And indeed, Monday’s market action gave us a powerful bounce from support, back above the 50-day simple moving average.) Apparently, the latest pullback served as yet another opportunity to refresh bullish conviction.
The 100-day simple moving average and the lower trendline joined forces to provide strong support. Oscillators RSI, MACD, and Slow Stochastic are all looking ready to turn back up bullishly. The pullback in early March created a bull flag continuation pattern that indeed was confirmed with an upside breakout, and last week’s pullback seems to have also formed a bull flag continuation pattern. Below the 50- and 100-day SMAs and the uptrend line resides the critical 200-day SMA, near 201, followed by round-number support at the 200 price level. From a technical standpoint, the SPY chart remains bullish, and the iShares Russell 2000 ETF (ARCA:IWM) small-cap chart is even stronger.
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, multi-factor 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. A high Bull score indicates that stocks within the ETF recently have tended toward relative out-performance 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 which represent the ten major U.S. business sectors: Financial (NYSE:IYF), Technology (NYSE:IYW), Industrial (NYSE:IYJ), Healthcare (NYSE:IYH), Consumer Goods (NYSE:IYK), Consumer Services (NYSE:IYC), Energy (NYSE:IYE), Basic Materials (NYSE:IYM), Telecommunications (NYSE:IYZ), and Utilities (NYSE: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 continues in first place with an Outlook score of 87. Technology displays the best return ratios, reasonably good forward long-term growth rate and forward P/E, and relatively sell-side analyst sentiment (net revisions to earnings estimates) -- although all sectors have been hit with net downgrades to forward estimates. Financial takes second at 84 and displays by far the lowest forward P/E, above-average forward long-term growth rate, and the best sentiment among insiders (buying activity). Healthcare takes third with a score of 80 on the strength of solid sell-side analyst sentiment. But then there is a big drop down to fourth place Industrial at 48, which is in mid-tier pack along with Utilities, Materials, Consumer Services (Discretionary/Cyclical), and Consumer Goods (Staples/Noncyclical).
2. At the bottom sits Energy and Telecom. Energy continues to hold the bottom spot with an Outlook score of 8 given the persistent weakness in oil prices and the ongoing downward earnings revisions from Wall Street (although the magnitude of downward revisions has lessened). Energy is among the worst in all factors in the model, and in fact its forward long-term growth rate is virtually zero.
3. Looking at the Bull scores, Industrial and Financial display the top score of 60, followed by Technology, Healthcare, and Materials. Utilities scores the lowest at 51. Notably, all scores are above 50. The top-bottom spread remains narrow at 9 points, which reflects high sector correlations (i.e., broad risk-on buying). It is generally desirable in a healthy market to see low correlations reflected in a top-bottom spread of at least 20 points, which indicates that investors have clear preferences in the stocks they want to hold.
4. Looking at the Bear scores, Energy and Consumer Services (Discretionary/Cyclical) display the highest (i.e., best) score of 49, which means that stocks within these sectors have been the preferred safe havens (relatively speaking) on weak market days. Utilities and Industrial share the lowest score of 41. Notably, all scores are below 50. The top-bottom spread remains a narrow 8 points, which reflects high sector correlations on particularly weak market days (i.e., broad risk-off selling). Ideally, certain sectors will hold up relatively well while others are selling off. Again, it is generally desirable in a healthy market to see low correlations reflected in a top-bottom spread of at least 20 points.
5. Technology displays the best all-around combination of Outlook/Bull/Bear scores, while Energy and Telecom share the worst. Looking at just the Bull/Bear combination, Consumer Services (Discretionary/Cyclical) is the strongest, followed by Energy, indicating superior relative performance (on average) in extreme market conditions (whether bullish or bearish). Utilities scores the worst.
6. Overall, this week’s fundamentals-based Outlook rankings still look mostly bullish to me, with the top four (and six of the top seven) economically-sensitive or all-weather. Defensive sectors Consumer Goods (Staples/Noncyclical) and Telecom rank near the bottom. However, 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.
h3 Stock and ETF Ideas:/h3Our Sector Rotation model, which appropriately weights Outlook, Bull, and Bear scores in accordance with the overall market’s prevailing trend (bullish, neutral, or defensive), moved to a neutral bias at Friday’s close, and suggests holding Technology, Financial, and Healthcare, in that order. (Note: In this model, we consider the bias to be neutral from a rules-based trend-following standpoint when SPY is between its 50-day and 200-day simple moving averages.)
Other highly-ranked ETFs from the Technology, Financial, and Healthcare sectors include First Trust NASDAQ CEA Smartphone Index Fund (NASDAQ:FONE), First Trust NASDAQ ABA Community Bank Index Fund (NASDAQ:QABA), and First Trust NYSE Arca Biotechnology Index Fund (NYSE:FBT).
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, Financial, and Healthcare sectors include Avago Technologies (NASDAQ:AVGO), Skyworks Solutions (NASDAQ:SWKS), Western Alliance Bancorp (NYSE:WAL), Bank of the Ozarks (NASDAQ:OZRK), BioMarin Pharmaceuticals (NASDAQ:BMRN) and Medivation (NASDAQ:MDVN). All are highly ranked in the Sabrient Ratings Algorithm .
If you prefer to maintain a bullish bias, the Sector Rotation model suggests holding Financial, Technology, and Healthcare, in that order. And if you prefer a defensive stance on the market, the model suggests holding Healthcare, Consumer Services (Discretionary/Cyclical), and Technology, in that order.
IMPORTANT NOTE: 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/defensive 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.
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