ETF Update: Health Care Legislation and Drug Stocks

Health Reform legislation seems to be assured of passage.  As I have suggested in past articles, all viewpoints are represented aggressively.  It is leading to a compromise that will not be loved by anyone, but will constitute a major policy change.

The Democrats, dealing with the known bottleneck of averting a Senate filibuster, have made the needed changes.  The liberal wing hates the changes, including some who want to start over.  The marginal voters have exploited their positions in virtually eliminating a "public option" and in limiting public funds for abortions.  The Republicans have gone all out to block any bill, pulling out all stops.  By insisting on the reading of every amendment and forcing procedural votes, they hope to delay the legislation despite the apparent super-majority in favor.

Each faction is using the best possible strategy.  The result?  It is not the best possible bill, but it might be the best bill possible.  Here is a nice summary of the compromises.

My focus this week is on another group of stocks affected by the health care legislation -- pharmaceuticals.

Background

Each week we provide a list of sectors that we expect to have the best performance over the next three weeks.  ETF investors can check out the list and compare our findings with their own conclusions.

In our analysis, we consider Trends, Cycles, and a bit of Anticipation.  While our ratings share characteristics with momentum and relative strength approaches, there are important differences.  Since we apply the model to nearly 300 ETF's, we call it the TCA-ETF system.  (For new readers, there is a more complete description of our methods at the end of the article.  We also have a free report with more detail on the system and results, available on request.)

The model provides a nice feel for the overall potential of the market.  It is not the forest nor the individual trees, but something in between.  I'll take a look at the macro picture first, and then take a look at our featured sector of the week.

The Macro View

From an overall market viewpoint, our indicators show continued risk.  The key elements are as follows:

• 84% of our ETF's in positive territory (up a touch from 81% last week).  The median strength rating for the overall list is a plus 21 (up slightly from +19 last week).   A score of "0" implies the average long-term ETF expectancy.
• We see reduced risk, with 66% (down from 88%) of our sectors are in the "penalty box."  This means that they are currently disqualified from the buy list for technical reasons.  You can think of this as a sophisticated "stop loss" rule, often applied in advance.  It also may indicate the need to take profits in a sector where we have done well, but see higher risk.  See our article here for a further explanation of this method.  We recently implemented some faster filters, accelerating moves both into and out of the Penalty Box.  We are also changing some rules to cut down the frequency of trading.
• Our index package is positive.  For this rating we look at the ETF's (both long and short)  for the S&P 500, the Dow, and the Nasdaq.  You can see these ratings is the results table for this week.  Despite the positive ratings, we note risk in both directions.  All of the index ETF's are in the penalty box.

This overall picture has been about the same for several weeks, but is showing slight improvement.

Highlighting Pharmaceuticals

Our featured ETF in the drug sector is SPDR S&P Pharmaceuticals ETF (XPH).  The fund has 24 holdings with very equal balance.  The beta is only 0.71.  The trailing P/E is almost 18.  As is the case with many equity opportunities this year, there is a dramatic difference between trailing and forward P/E's.  In this case, looking ahead shows a P/E ratio of 11.6.  This compares favorably with estimated earnings growth of about 17%.

As the chart shows, this is not the bottom in the sector, but it could still represent a good opportunity.

Other Experts

Among our regular experts there has been little discussion of the drug ETF's in recent weeks.  The best perspective came from Tom Lydon, who noted the following in November:

Each administration brings its own set of policies to the White House. Investing in ETFs may be a prudent way to experience a potential windfall from the country’s new direction without the high volatility inherent in individual stocks.

Lydon also has a nice piece describing innovation and the role of biotech in the pharma ETF's.

There is also some mention of health care ETF's in the monthly Seeking Alpha panel discussion.

Fundamentals and Health Reform

At our ElectionStocks site we have followed the twists and turns of the health care legislation in a series of articles.  I also emphasized this last week, describing the process of building a minimal winning coalition.

In particular, this article showed that there was more visibility on drug stocks.  The major companies agreed to a payment of $80 billion, about 2-3% of revenues.  That clarified the impact and helped investors see the potential.

As usual, I have tried to emphasize the need for investors to focus not on their own policy preferences, but on the likely policy outcome.  There is always a way to profit if you are a political agnostic.  We should all try to profit from policy changes no matter which party is in power, and regardless of our own opinions about what is best.  The actual legislation is a compromise that will help the health care stocks.

Weekly TCA-ETF Rankings

We lost about 1.3% last week, dropping 1.0% to the S&P 500.  The expiration-week activity created some volatility.  The dollar showed some strength, a short-term negative for most stocks.  There was continuing uncertainty on health stocks, now getting clarified.  The strength came from strong earnings reports in some tech stocks.

We provide these ratings as information for readers who may not trade as frequently as we do.  Those signing up for our free weekly email update can also get the entire list.

As noted above, the macro market indicators are in the penalty box, and most other ETF's are in the penalty box.  Based upon the current model signals (and noting the high risk levels), we have continued our bullish posture in the Ticker Sense Blogger Sentiment poll.

Here are the top sectors from our expanded universe of 280 ETF's.  The list also includes the values for the broad market ETF's and their inverses.

Note for New Readers

Our weekly ETF Update is designed to assist both investors and traders interested in ETF's and Sector Rotation.  Before turning to the current rankings, let us undertake a review for readers new to this series.

Our Method.  In this past article, we described our basic methodology and why we believe the rankings are useful for fundamental traders and technical traders alike.  While we urge readers to check out the entire article, the key point is that ETF's pose challenges and opportunities different from investment in individual stocks.  The fundamentals may be more difficult to assess.  Even with a good grasp on fundamental trends, there is a lot of technically-based trading in ETF's.  This means that those trading with a fundamental approach (and we do this as well) want to monitor the "hot money" moves.  Here is an article on that point.

The system synopsis. We look at Trending sectors, Cyclical Sectors, and build in an element of Anticipation for both entry and exit -- thus the name of the model, TCA-ETF.  While we do not reveal the exact methodology for spotting trends and cycles, the system is not a "black box."  The basic elements are used by many, and widely reported.  We even discuss the need for human analysis as opposed to black box trading.

We report the rankings each week, now on the weekend with a one-day delay, using the Thursday output from the model.  We monitor and trade this daily, and offer a free report (request via the email address on the top left of the site) for those interested in our weekly trading program.