With This Current Sector Rotation, Your Best Bet Is to Follow the Crowd  

All we've heard for the last month or so is how the market is undergoing a tremendous rotation between sectors.

The migration of money from perceived overvalued groups into better values has changed the performance landscape, but is it worth following the crowd?

In most cases, I preach that being part of the crowd is one of the more dangerous moves.

This is because crowded trades tend to be so at their tops, not bottoms. But in a small number of cases, a few of the leading sectors are showing signs that they've yet to become crowded trades.

The following table displays the top-performing, widely traded ETFs since the beginning of July.

sector rotation

The sector rotation has prices in healthcare and related groups outperforming the market. These, of course, had been some of the market's underperforming sectors for some time.

Topping the list is the SPDR S&P Pharmaceutical ETF, which has left the market in the dust over the last month or so, returning more than 12%.

Normally, I would back away from a potentially overbought, crowded move like that, but let me explain why it's different in this case.

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The Numbers Say There's Room to Keep Moving Higher

According to my Best in Breed system, XPH shares are far from being crowded.

The latest composite weighted short interest data for the ETF shows it to be the second most heavily shorted group, with Biotech ETF (XBI) holding the top spot.


The heavy short interest among the pharma companies suggests that the sector is likely to benefit from continued short covering as it makes its way deeper into August.

My system is also showing that 62% of the companies within the ETF are trading above their respective 50-day moving averages. In addition, 57% of the same companies have 50-day moving averages that are trending higher, a bullish indicator by itself.

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The Pharmaceutical ETF also has a seasonal tailwind to help through August. According to my system, the ETF has outperformed the S&P 500 62% of the time in August over the last 13 years.

The easy play could be a buy of the XPH shares themselves, but what about if you want to dive into the sector for an individual name?

According to my Best in Breed system, there are a number of names in the XPH that are set to outperform the market. That said, let's take a look at one of the lesser-known names in the sector that's caught my attention...

Little-Known Pharma Company, Big Profit Potential

Mallinckrodt Plc. (NYSE: MNK) is a global specialty pharmaceuticals company.  The company develops, manufactures, markets, and distributes branded and generic specialty pharmaceutical products and other medical agents.

Shares of Mallinckrodt got a shot in the arm last week when the company beat earnings expectations and raised their forward-looking guidance. The move is just part of the recovery that started in May when the stock placed a long-term bottom at $12.

Now, the technical picture is flashing bullish signs as a Golden Cross pattern is forming, indicating a strengthening of the long-term trend. In addition, a break above $31.60 will officially mark the beginning of a new long-term bull market trend for the stock.

Putting the cherry on top of this trade is the fact that the shorts have been betting against this recovery. The short interest ratio for Mallinckrodt sits at 13.0, one of the higher ratios in the sector. This indicates that a short-covering rally is likely to be triggered, adding to the buying volume at a rapid pace.

Put all these factors together, and my models point to a price target of $37, a 23% move before year's end.

The simple play on Mallinckrodt is to be a buyer of the stock and ride it to the $35 price target. Those traders interested in leveraging the move should consider an at-the-money January call option on the stock. These options are currently trading at just under $5.

pharma ETF

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About the Author

Chris Johnson (“CJ”), a seasoned equity and options analyst with nearly 30 years of experience, is celebrated for his quantitative expertise in quantifying investors’ sentiment to navigate Wall Street with a deeply rooted technical and contrarian trading style.

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