Sector Detector: Energy Tries To Fuel Year-End Rally, Tech Is A Drag

Like the nice employer who never fails to pay a Christmas bonus every year, Santa seems bound and determined to give bulls the year-end rally they have come to expect. But bears aren’t going away quietly—although bulls got some unintended help from the bears with Tuesday’s short-covering-fueled rally.

Among the ten U.S. sector iShares, Energy (IYE) has been the leader so far this week through Wednesday, followed by Consumer Goods (IYK) and Basic Materials (IYM). The big laggard has been Technology (IYW), due to Oracle’s (ORCL) disappointing earnings miss. In fact, through Wednesday, IYW was the only one of the ten sector iShares that was in the negative for the week. Nevertheless, the rest of market seems to be ignoring any broader implications of the ORCL report, which is a positive thing.

One market segment that has been consistently strong in this unpredictable market is the Pharmaceuticals industry, which is a subset of the Healthcare sector, and is a pocket of strength that keeps the iShares Dow Jones U.S. Healthcare ETF (IYH) consistently scoring highly in the Sabrient SectorCast rankings. In fact, IYH ranks at the top this week.

Looking ahead, investors certainly have plenty to worry about. As usual, the main story is the lack of a confidence-inducing solution to the debt crisis in Europe. The credit rating agencies have been downgrading credit in the region, while the ECB has refused to aggressively buy bonds to keep rates down. However, the ECB did come through with a bigger than expected refinancing operation in 3-year loans (rather than the standard 1-year) to European banks. A European solution would keep a solid bid under the euro, but otherwise the dollar will be relatively strong, which hurts both stocks and commodities.

Beyond that dicey situation, we have the polarized U.S. Congress, which has given us the U.S. budget ceiling non-solution and now the threat of expiration of the payroll tax cut and unemployment benefits. Then there are the potential instabilities from the U.S. presidential election process, Russian elections, economic slowdown in emerging markets, North Korea’s leadership succession, the threat of Sunni/Shiite civil war in Iraq, and continued uprisings in the Arab world.

But if we look at the home front, the economic numbers continue to improve in fits and starts, and investors have been taking notice. Unemployment, home sales, industrial production, and consumer confidence have all shown improvement. Inflation remains tame and borrowing rates remain historically low. Combine these with any sign of positivity in Europe, such as the successful bond auction in Spain, and stocks have a reasonable foundation from which to move higher—particularly with valuations so attractive on a historical basis.

Now let’s look at the charts. The SPY closed Wednesday at 124.17. In last week’s blog post, I drew a symmetrical triangle formation on the chart and suggested that a test of support was occurring at the convergence of the lower line of the triangle and the 100-day simple moving average. I further suggested that “a confirmed failure of the triangle would pretty much put a final dagger in any chance of a Santa rally, but a bounce from this level might be just the ticket for the sleigh ride.” Well, it appears that support held, and now it is looking for interim support to hold on a closing basis at the 50-day moving average before making a run at the upper line of the triangle and the 200-day moving average.

The VIX (CBOE Market Volatility Index – a.k.a. “fear gauge”) (VXX) closed Wednesday at 21.43. It has been downtrending, which is bullish for equities. It has put 30 firmly in the rearview mirror, just when it seemed that 30 would be the new floor in a high-volatility environment, and now VIX seems to have its sights set on support at 20.

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 its climb since the first of August. It hit another 52-week high this week before closing at 57.12 on Wednesday. This is far above the low teens from earlier this year, and indicates elevated investor worry about bank liquidity and a preference for the safety of Treasuries bonds over corporate bonds.

Latest rankings: The table ranks each of the ten U.S. industrial sector iShares (ETFs) by our 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 our 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

After a brief appearance at the top last week, Energy has fallen to fourth this week. Its outperformance over the past few days might have something to do with that. Healthcare moves into the top slot with an Outlook score of 73. Financial (IYF) makes a big 17-point jump from fifth place to second, with a score of 66, which is just ahead of Technology at 65 and IYE at 64. IYF still sports the best (lowest) projected P/E, while IYH retains good analyst support each week.

Former leader Basic Materials continues to be held back by net downward revisions by the Wall Street community; although it still sports a low projected P/E. Apparently investors still think the analysts are too optimistic, even with the downward revisions. Consumer Services (IYC) has been receiving the most support among analysts with net earnings upgrades, which is an encouraging sign for the economy, but it is held back by tight margins and a relatively high projected P/E.

As usual, Utilities (IDU) and Telecom (IYZ) are in the bottom two. Stocks within these ETFs are saddled with the highest projected P/Es.

Seeing IYW, IYE, IYF, and IYJ in the top half is a relatively bullish sign. It would be better to see IYM and IYC scoring above IYK, and to see a top score above 80. As a whole, the Outlook rankings for the 10 U.S. sector iShares reflect cautious optimism.

Looking at the Bull scores, IYE has been the leader on strong market days, scoring 60, followed by IYM and IYF. IDU remains the weakest with a 40. It is notable that IYW is not a leader on strong market days.

As for the Bear scores, IDU is the clear investor favorite “safe haven” on weak market days with a score of 65. IYH has passed up IYK for second at 62. IWM displays the lowest Bear score of 40, which means that stocks with this ETF sell off the most on weak market days.

Overall, IYH displays the best combination of Outlook/Bull/Bear scores. Adding up the three scores gives a total score of 179. IYZ is the worst at 112. IYE and IYH are tied for the best combination of Bull/Bear with a total score of 106, while IYW has the worst combination (98).

Top ranked stocks in Healthcare and Financial include Anika Therapeutics (ANIK), Momenta Pharmaceuticals (MNTA), Republic Bancorp (RBCAA), and World Acceptance Corp (WRLD).

These scores represent the view that the Healthcare and Financial 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.