Day Hagan Research Update

DAY HAGAN RESEARCH UPDATE

ETFs With Fundamental Support

SUMMARY

Discretionary, Home Construction, Regional Banking and Tech-Software all have greater than 5% earnings and sales growth.

WRITTEN BY

Neil Leeson

POSTED

November 23, 2016

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For domestic equity allocation I focus on 22 distinctive industry group ETFs. Like all of our research, we rely on multiple indicators and factors to guide our investment choices. Recently, I have been focused on overbought and oversold indicators (OBOS), because I don’t want to get caught chasing funds that are overbought, and want to avoid catching a falling knife on extremely oversold funds. OBOS indicators should be treated like sentiment indicators, where the reversal from extremes is more important than the extreme level itself.

While I am more focused on the technical side of the market, fundamental strength and improvement is what’s going to push this market to higher highs. In last week’s Research Update, I wrote about earnings expectations for 2017 and found that stocks underlying Energy, Regional Banks and Technology ETFs had the highest expected earnings improvement for next year.

Today, I have screened 22 industry ETFs for funds where the median earnings growth (short- and long-term) and sales growth for the underlying constituents is greater than 5%. I have also reviewed three different mean reversion metrics so I can better identify entry points. While fundamental measures are longer term in nature, getting a good entry point is also important.

Of the 22 ETFs I screened, only four met the 5% threshold:

  • ITB iShares U.S. Home Construction ETF
  • XLY SPDR Consumer Discretionary Select Sector ETF
  • KRE SPDR S&P Regional Banking ETF
  • IGV iShares North American Tech-Software ETF

The Home Construction ETF (ITB) has the highest growth measures across the board. However, on a short-term basis (2-week Mean Reversion), fund pricing has exceeded the two standard deviation threshold, suggesting that the fund is overbought on a very short-term basis. Longer-term mean reversion measures show a fund that is neither overbought nor oversold. XLY, the Discretionary ETF, has the same OBOS conditions as ITB. KRE, the Regional Bank ETF, is extremely overbought over all three time frames, whereas IGV, the Tech-Software fund, could be classified as “neutral” on these measures.

As shown on the chart below, the median long-term earnings growth for the contituients has remained near the 20% level for the past two and a half years after picking up in early 2014. This illustrates that as a group the stocks that make up ITB have fairly steady earnings growth.


ITB Median LT Earnings Growth

While the fundamentals are supportive, ITB has reached overbought levels. As shown below, historically, once this fund breaches the two standard deviation level (only 2.18% of the time over the past 10.5 years) gains have been negative (-35.14%), and four and 12 weeks after reaching this level the fund has pulled back significantly (-5.95% and -7.29% respectively). Such extremes suggest that there is currently more downside risk than upside return in the near term. Therefore, ITB is on our watch list to purchase at a lower entry point.


iShares US Home Construction (ITB) Mean Reversion

Regional banks have been on a tear lately, and earnings and sales growth remain supportive. However, current prices for this ETF have pushed the fund well into overvalued territory (below).


SPDR S&P Regional Banking ETF Total Return Valuation Factor Model

In addition to KRE being at overvalued extremes, the fund is at overbought extremes as well (below). Extreme valuations on securities are not typically good timing indicators. A fund/stock/index can, and often will, go far beyond extremes in valuations when investor fear/greed has taken over. And like valuation extremes, prices can get farther and farther overbought/oversold when herd mentality takes over. This is why it is best to go with the extreme if you already own the fund, and wait for a reversal to reduce, hedge, or exit a position. But for new allocation, we need to see a reversal to more “normal” levels in order to start initiating a position.

In sum, we are looking at valuation measures to evaluate potential allocation candidates, and OBOS measures to evaluate the current pricing environment.


SPDR S&P Regional Banking ETF (KRE) Mean Reversion

Have a wonderful week,

Neil Leeson
Day Hagan Investment Committee Consultant
Day Hagan Asset Management

Written 11.22.2016

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