By Scott Martindale
President, Sabrient Systems LLC
On Wednesday afternoon, the Fed came through to fulfill what was widely expected – no change to the discount rate just yet. But it did pump up its hawkish language a bit. The FOMC never wants to surprise the markets, so given that it had not telegraphed a rate hike, it simply wasn’t going to happen. Looking forward, however, given that the committee sees the balance of economic risks at an equilibrium, a hike in December looks like a slam-dunk unless something changes dramatically. Beyond that, they are essentially telegraphing two rate hikes next year, as well. The upshot is that investors were happy and dutifully responded with a strong rally across many asset classes to finish off the day.
In this periodic 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 ETF trading ideas.
After the Fed announcement, the S&P 500 finished the day up +1.1% to close at 2,163, Russell 2000 +1.3% to 1,245, oil +2.6% to $45.62, and gold +0.9% to $1,339, while the VIX finished down -16.5% to close the day at 13.30. Even Treasuries were bought as the 10-year yield fell 2 bps to close at 1.67% and the 30-year yield fell 3 bps to 2.40%. Notably, the 2-year T-bill rose nearly 5 bps earlier in the day but then fell 6 bps immediately after the rate announcement before closing right about where it started the day, at 0.77%. CME fed funds futures now place 59% odds of a rate hike at the December meeting. Although there is a November meeting, no one seriously expects a rate hike right before the elections.
Investors remain generally nervous about putting their idle cash to work. Thus, there is no whiff of irrational exuberance, and many commentators see this as a contrarian sign for even higher prices in the future. Although valuation multiples are elevated, stocks still look pretty good relative to other asset classes. Bonds, for example, are not cheap.
No doubt, the economy has been overly reliant on the Fed. By keeping borrowing rates low and liquidity high, monetary stimulus has led to elevated and correlated asset prices without creating broad price inflation, mainly because the multiplier effect has been non-existent as banks have been reluctant to lend given low rates and a relatively flat yield curve. Furthermore, accommodative monetary policies have been offset by relatively tight fiscal policies, so it is time to pass the baton to our elected officials to create stimulative fiscal policies and structural/regulatory reforms that have been so badly missing. Of course, this likely won’t happen until after the November elections.
I admit that the high correlation across asset classes is concerning. After an unusually calm summer, volatility and asset correlations suddenly jumped. On September 12, the VIX briefly reached above 20, which is essentially the “panic” threshold. Stocks and bonds have been moving in tandem during September, and their correlation hit a 17-month high, mostly due to fears about Fed actions. There is real fear that the end of QE and rate “normalization” will hurt both bonds and stocks.
On the other hand, looking solely at US equities, sector correlations to the S&P 500 have been falling this year. ConvergEx recently reported an average correlation of about 78% over the past couple of months, compared to the 5-year average of 82%. The firm thinks that the average correlation eventually will come back down to the 50% range, which would be a healthy and welcome trend.
I still believe conditions remain positive for US equities. I continue to see a healthy broadening of the market and falling sector correlations to the broad benchmark, which indicates that investors are showing greater preference for what market segments they want to own, as opposed to a news-driven risk-on/risk-off approach. Biotechs, in particular, are looking strong and could be setting up for significant rally.
Most notably, I think US equities still look relatively attractive when compared to the alternatives, given the low yield environment, low inflation, strong housing, robust corporate stock buybacks, abundant global liquidity, foreign capital flowing into the US, good job growth, modest wage inflation, low fuel prices, solid consumer spending, expected improvement in corporate earnings growth (although perhaps not quite as fast as previously predicted), and an abundance of cash on the sidelines (desperately seeking an opportunity). All that is really needed to really get things going is expansionary fiscal policy.
SPY chart review:
The SPY closed Wednesday at 215.82. September brought a jolt to the quiet summer trading range, and SPY suddenly lost support from its 50-day simple moving average but found solid support at the 100-day SMA. It then formed a symmetrical triangle pattern (neutral, indicating indecision) leading into the Fed’s rate decision, which resolved in an upside breakout. Support-turned-resistance resides overhead at 217, which coincides with the 50-day SMA, but I don’t think it will prove very difficult to eclipse now that the Fed has gotten out of the way (at least for the time being). Solid support can be found at 100-day SMA (near 213), and prior resistance-turned support at 210, followed by 208, the 200-day SMA (near 206), and then a prior bullish gap from 204. Oscillators RSI, MACD and Slow Stochastic are all pointing up bullishly after cycling down to work off their overbought conditions. I continue to like the overall technical picture.
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.
Here are some of my observations on this week’s scores:
1. Technology retains the top spot with a robust Outlook score of 85. Stocks within the sector generally display among the best Wall Street sell-side analyst sentiment (net positive revisions to earnings estimates) and insider sentiment, solid return ratios, a reasonable forward P/E of about 16.8x, a strong forward long-term EPS growth rate (13.9%), and the lowest forward PEG of 1.2 (ratio of forward P/E to forward EPS growth rate). Healthcare comes in second with an Outlook score of 70 and displays an attractive forward P/E of about 15.7x and the second lowest forward PEG of 1.4. Rounding out the top five are Financial, Basic Materials, and Industrial, which is a bullish group. Financial still displays the lowest forward P/E of 15.0x.
2. Energy and Telecom remain in the bottom two. Nevertheless, Energy displays the second highest forward long-term growth rate of 13.3% (albeit because of a low bar for prior-year comps) and improving sentiment among both Wall Street analysts (net revisions to earnings estimates) and insiders (open market buying), but it is held back by a high forward P/E (32.9x), a forward PEG of 2.5, and weak return ratios. Telecom also displays a relatively high forward P/E (24.3x) and forward PEG (2.3).
3. Looking at the Bull scores, Energy has the top score of 60 as it displays relative strength on strong market days, while Healthcare is the lowest at 44. The top-bottom spread is 16 points, which reflects moderately low sector correlations on strong market days, which can be good for stock picking. It is 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 (rather than broad risk-on behavior).
4. Looking at the Bear scores, Utilities displays the top score of 54, which means that stocks within the sector have been the preferred safe havens lately on weak market days. Fellow defensive sector Telecom surprisingly scores the lowest at 42, as investors flee during market weakness. The top-bottom spread is only 12 points, which reflects relatively high sector correlations on weak market days, which isn’t great for stock picking. Ideally, certain sectors will hold up relatively well while others are selling off (rather than broad risk-off behavior), so it is 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 Telecom is by far the worst. However, looking at just the Bull/Bear combination, Energy is by far the best, indicating superior relative performance (on average) in extreme market conditions (whether bullish or bearish), while Telecom is the worst.
6. This week’s fundamentals-based Outlook rankings look quite bullish to me given that the top five sectors include traditionally all-weather Healthcare and economically-sensitive Technology, Financial, Basic Materials, and Industrial, while defensive sectors Consumer Goods (Staples/Noncyclical), Utilities and Telecom are ranked in the bottom five. Keep in mind, the Outlook Rank does not include timing, momentum, or relative strength factors, but rather is a reflection of the fundamental expectations for individual stocks aggregated by sector.
ETF Trading 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 defensive), moved to a neutral bias when SPY lost support at its 50-day SMA, but post-Fed action might quickly push it back to a bullish bias. Nevertheless, a neutral bias suggests holding Technology (IYW), Healthcare (IYH), and Financial (IYF), 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 on the rebalance day.)
Besides iShares’ IYW, IYH, and IYF, other highly-ranked ETFs in our SectorCast model from the Technology, Healthcare, and Financial sectors include First Trust NASDAQ Technology Dividend Index Fund (TDIV), SPDR S&P Pharmaceuticals ETF (XPH), and PowerShares KBW Bank Portfolio (KBWB).
An assortment of other ETFs that are scoring well in our rankings include Global X SuperDividend REIT ETF (SRET), PureFunds ISE Mobile Payments ETF (IPAY), First Trust NASDAQ Rising Dividend Achievers ETF (RDVY), Direxion All Cap Insider Sentiment Shares (KNOW), which tracks a Sabrient quant index, and the First Trust LongShort Equity ETF (FTLS), which employs Sabrient’s proprietary Earnings Quality Rank as a key input factor.
However, if you think the SPY is back on an upward trajectory and prefer a bullish bias, the Sector Rotation model suggests holding Technology, Energy, and Basic Materials, in that order. On the other hand, if you are more comfortable with a defensive stance on the market, the model suggests holding Technology, Healthcare, and Financial, in that order (same as the neutral stance).
IMPORTANT NOTE: I post this information periodically 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 on a regular schedule. 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 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 ideas mentioned here as a managed portfolio.
Disclosure: The 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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