Simple Quant Models Capture Alpha in January; Low-Quality Stocks Sell Off

by: Stephen Castellano

For a detailed pdf of the January 31, 2010 Ascendere Associates LLC Long/Short Model Portfolio Strategy, follow this link.

That giant sucking sound you may have been listening to was the sharp erasure of a 3.15% gain in the S&P 500 that was in place as of January 19, with the index ending the month at a 3.697% loss (excluding dividends). "Sell first ask questions later;" "Too far too fast" -- these are probably the best and only explanations required to describe what happened in January.

It is with a newfound appreciation for the power of technical momentum that many investors -- and not just traders any more -- have probably learned how to pull the sell trigger. Perhaps many have realized by now that it is ok to give up some upside in to prevent the possibility that your assets do not roll off a cliff.

To summarize in more detail, everything seemed pretty rosy through January 19. But a day later China announced it would curb lending practices due to inflationary concerns. Since most businesses are at least partially counting on a Chinese economic recovery to drive further orders, this came as a sharp disappointment to investors, especially those invested in Materials and Industrial stocks.

Joy Global and the fate of other Material and Industrial Stocks
Look at Joy Global (JOYG) for example, which Ascendere Associates LLC discussed back in December, or almost any stock related to the fortunes of the Materials sector. Not even a month ago it seemed sensible to bet slightly in favor for a global economic recovery driven in part by growing demand in China. A recent article in the Wall Street Journal that discussed the preparations that Caterpillar (NYSE:CAT), its suppliers and others were making for a possible inventory order bullwhip effect could have been interpreted as one piece in the mosaic confirming some sense of optimism. Perhaps now, just a few days later, it may make more sense to backtrack on these growth assumptions. Or maybe at least for just a day or two at least.

President Obama Goes After Wall Street, and Other Negative News
Also in mid January, other negative stories were getting attention. Obama threatened the foundations of the market itself -- access to liquidity -- when he threatened to limit bank's abilities to engage in proprietary trading. Other stories, like a possible default in Greece, a gain in first-time unemployment claims, or a decline in a manufacturing index just added to the uncertainty. Investors already anxious by this news may have felt further depressed by IBM's currency-driven (low quality) revenue gains and conservative guidance, and Google's (NASDAQ:GOOG) earnings miss coupled with an ongoing spat on censorship with the Chinese government. The list could go on.

The Golden Rule
Humans live in a world of analogies and causation, whether real, illusory or self-fulfilling. It seems that the golden rule of anything and everything -- good, bad, life, love, markets, tooth decay, number of P90X abdominal crunches that are possible in the middle of the day by an underemployed equity research analyst -- is that momentum begets momentum. Recent history seems to suggest that once markets start selling off or investors start focusing on negative stories (it does not seem to matter which occurs first), it could make sense to sell socks -- no matter how much of Graham & Dodd or CFA Institute books you have studied to justify the previous day's purchases. And this could especially be true for those "low-quality" stocks that have appreciated due solely to anticipation of better macro news ahead. This is not to advocate simple momentum-based investing, but just to be cognizant of what is occurring in the market and let it play a factor in decision making.

Long Ideas for February 2010
It is in that vein that we present 41 fundamental long stock ideas in the Ascendere Associates LLC Long/Short Model portfolio that may be worth reviewing, while acknowledging that only 15 of them show any price momentum as of January 31, 2010. These include the following: ROST, AZO, GCI, CMG, SNI, DV, RAI, KOF, PRE, CIM, FITB, NYB, WFC, ABC and GILD.

McKesson, "Possibly the Best Stock to Own," is Off the Long Idea List
Why is McKesson Corp. (NYSE:MCK) --The Best Possible Stock to Own in the Healthcare Sector that we wrote about on January 27 -- not on this long stock idea list just two trading days later? A single factor -- that of relative analyst revision momentum -- just declined slightly below a level that we look at, though it is still higher than the majority of Healthcare stocks. Other MCK metrics continue to look excellent, specifically in ROIC momentum, relative value and balance sheet strength; and its shareholder-oriented management team deserves positive attribution. We continue to think of MCK as a great long stock idea situated in a sector with solid long-term growth prospects.

Short Ideas for February 2010
We offer up 46 potential short ideas for February, of which 40 seem to be confirmed by recent stock price action and may be worth reviewing: ANF, GT, HOG, DAI, BRFS, BG, COG, ANR, BWP, RDS.B, NXY, WFT, HK, AVB, AXA, BK, AMG, DB, REG, ALL, AMB, AIG, KSU, HTZ, PCAR, ATVI, ERTS, POT, FBR, GGB, MOS, STLD, NUE, X, PT, SCG, SO, FPL-OLD, POM and TAC.

(Intuitively it does not make sense to me that Activision Blizzard (NASDAQ:ATVI) is a good short idea, even though the numbers say otherwise. In fact, this could be a great long idea because it is the fundamentally ugly looking stocks with good management and good pipelines that explode higher on justifiably positive news. I am thinking potentially of the pending three-volume release of Starcraft II (whether in months or years -- Blizzard has a reputation for delaying the release of games until they are nearly perfect), backed by recent momentum in other titles like Guitar Hero and Modern Warfare2. The predecessor game, Starcraft, was possibly the best selling PC-based game for several years when it was released back in 1998. This may be just another example as to why it is prudent to do one's homework before following any kind of list.)

Discussion of the Model Portfolio Results
The Ascendere Associates LLC Long/Short Model portfolio finished January 2010 up 1.75%, versus a decline of 3.70% in the S&P 500 (excluding dividends). Over the 5+ years of its backtested inception, the model strategy is up 201.7% versus a 9.3% cumulative decline in the S&P 500.

Cumulative Backtested Returns -- 2010 01 31
Cumulative Backtested Returns 2-- 2010 01 31

The model portfolio in January benefited largely from prescient sector weightings and a simple technical long/short weighting strategy as opposed to outstanding individual stock picking, though that did help to an extent. The model portfolio turned net short on January 28 and enters February 2010 in a net short position.

Driving the net positive performance of the model portfolio were underweighted long positions in Consumer Staples, Energy and Materials, and accurate and significant weighted bets in Healthcare and Utilities. Also, in general, the magnitude and accuracy of short stock picks more than offset the generally poor performance of long stock picks.

Ascender Equity Strategy Peformance -- 2010 01 31
The best performing long stock pick in the model portfolio was the large cap biotech company Gilead Sciences Inc. (NASDAQ:GILD), up 11.6%. The worst was the mid cap Brazilian cable tv and broadband provider Net Servicos (NASDAQ:NETC), down 12.6%.

Ascender Equity Strategy Long Performance -- 2010 01 31

On the short side, the best performing stock was Brazilian steel company Gerdau S. A. (NYSE:GGB), down 21%, and the worst selection was Genworth Financial (NYSE:GNW), up 21.9%. Arcelor Mittal (NYSE:MT) and Nucor (NYSE:NUE) -- two of the biggest "mistakes" in the short portfolio last month -- did well in January, declining 15.5% and 12.5%, respectively.

Ascender Equity Strategy Short Performance -- 2010 01 31
Let's take a look at one of the worst stock ideas, because therein is always a lesson worth learning. Genworth Financial (GNW) represents a simple lesson in why it can make sense for people -- an actual human -- to be in control of quantitative stock selection. In this case, GNW looked terrible on a quantitative standpoint because ROE was negative, making the case against ROE momentum and earnings quality. Furthermore, the magnitude and direction of positive analyst revisions was not high enough for the system to discard this stock as a short idea. A closer look at this company would have revealed that even though ROE was negative, consensus estimates implied that ROE could turn positive by the end of the March 2010 quarter. If that was not enough, the actual stock price momentum should have been a potential warning sign in of itself.

In our opinion, the Ascendere Associates LLC Model Portfolio continues to be a valuable tool in selecting stocks based on published data. As the markets settle and economic certainty returns, this model and others like it will return to favor.

Disclosure: No positions. We do not guarantee the accuracy of information or forecasts in this report. This is not a solicitation to buy or sell securities. Please do your own homework before buying any kind of securities.