Sector Rotation in 2013 - Part 4

by Wayne Ferbert on December 13th, 2012

In part 3, we introduced a value-driven analysis of 2600 different US stocks. As promised, in this part 4, we cross-examine our ratings with the sector ETFs we use to invest. Our favorite sector ETF family is the SPDR Sector Select ETFs from State Street. These ETFs cover the 9 sectors for each of S&P 500 companies.
We cross-matched our value investing ratings for all stocks (2600 in total) with the 500 stocks in the ETFs. We were looking to answer two questions:
  1. Do we see a concentration of the highest rated companies in any particular sector when we look at the actual MAKE-UP of the ETF itself?
  2. Since these ETFs are market cap weighted, do we see highly rated stocks among the highest concentrations?
We want to answer these questions because these are the ACTUAL investment vehicles with options that we will use to make our investments - and build our hedges. So, we want to know that the actual holdings in the ETF include the highest rated stocks from our analysis.
On the first question, our findings confirm that the Financials and the Energy sector have the most stocks that are under-valued on our traditional valuation measures. In fact, more than 30% of the stocks that make up the ETF for each of these sectors are among our highest rated stocks. That is HUGE!! There was not another sector that was even over 10%!
So, among the S&P 500 stocks, the Energy & Financials have many under-valued stocks. No other sector really stands out when we look at our top quintile of highest rated stocks.
But let’s examine what happens if we lower the bar a little bit and just look for the stocks that are above average in our ratings? The results don’t change. More than 2/3rds of the stocks in the Financials and Energy sector in the S&P500 are highly rated – but no other sector stands out as having a large proportion of stocks that are highly rated using our valuation criteria.
When we examine the 2nd question on market weighting of the ETFs, our results are further strengthened. The highest rated stocks in Energy and Financials are indeed the ones that represent a larger than average portion of the market capitalization of the ETF itself. In fact, while 2/3rd of the stocks in each of Financials and Energy are above average in rating, these stocks represent over 3/4ths of the market cap of the ETF.
In fact, the only other sectors that actually see a materially higher percentage of market cap rated above average compared to the count of stocks is Industrials and Technology. But when you isolate to only the HIGHEST rated stocks for these two sectors, you see the opposite. You find the highest rated companies are not above average in market cap for these two sectors.
Lastly, we built a market cap weighted average score for each ETF based on the market cap weighting in the ETF and the score we calculated for each of the 500 stocks in these ETFs. Remember that our scoring system assigned a score of between 4 (highest rated) and 20 (lowest rated). So, when we market cap weight the score, each ETF ends up with a score between 4 and 40.
Energy and Financials scored in at 9.43 and 9.53, respectively. No other sector even scored below 11.20. Remember that 12 would be the average score. So, with no other sector even scoring better than 11.20, you can see that no other sectors stand out statistically as a candidate for over-weighting.
In part 5 of the series on Monday, we will look at the price momentum that we see in each sector and consider what implications that momentum has on our buying and hedging decisions. In addition, we’ll examine why Technology no longer shows up as a sector favorite – given that we have been recommending it for the better part of 2011 and 2012.

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