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Market volatility spikes and settles as sovereign debt fears wreak havoc. The S&P 500 ended the month with a 2.85% gain (3.10% with dividends), but only after experiencing MTD returns that ranged from a low of -1.59% on February 8 to 3.29% on February 19. The implied volatility of S&P 500 index options as captured by the VIX spiked from a low of 21.08% on February 2 to a high of 29.22% on February 5, only to settle back down to 19.50% by month's end. Volatility seemed most correlated with concerns about sovereign debt risk, though disparate domestic economic indicators played a role as well.
Ascendere Long/Short Model Portfolio ends the month flat after a volatile month. In contrast, the Ascendere Long/Short Model Portfolio ended the month essentially flat (down 0.05%), ranging from a high of 1.90% on February 8 to a low of -2.41% on February 19. The decent performance of "low-quality" stocks anticipating an economic recovery, plus a flat footed 80%/120% long/short allocation negatively impacted the results relative to the S&P 500. For the YTD, the model portfolio is up 1.69% versus a decline of 0.96% (excluding dividends) for the S&P 500.
High quality stocks win the battle in February. For much of the month low-quality stocks were drastically outperforming high-quality stocks, causing us to wonder whether low-quality stocks were the treasures of tomorrow (see our February 19, 2010 report). But the month-end returns brought divine-like order to the fundamental equity universe. For example, a "low quality" stock in the model short portfolio, AIG, surged more than 16% on February 10, but only ended up roughly 2% for the month.
A market neutral portfolio returned 1.36% for the month versus the S&P 500 return of 2.85% (excluding dividends). The model long portfolio composed of high-quality stocks beating the SPX with a 4.02% return and the model short portfolio composed of low-quality stocks underperformed the SPX with a 2.48% return.
The long portfolio benefited from outperformance and overweight positions in the Consumer Discretionary and Materials sectors, as well as from avoiding entirely the Telecommunications and Utilities sectors. Healthcare, Industrials and Technology also outperformed relative to the S&P500, but these sectors were underweighted in the model portfolio. Long portfolio performance was hurt by its avoidance of Energy stocks, and underperformance in Staples and Financials.
The short portfolio performed extremely well relative to the S&P 500, benefiting from outperformance and overweighted short positions in the Consumer Discretionary, Financials, Healthcare, Telecom Services and Utilities sectors. Consumer Staples, Industrials and Technology short positions also did well relative to the S&P 500 but were underweighted. The short portfolio was hurt by significant price appreciation and overweighted positions in the Energy and Materials sectors.
The best and worst stocks in February may point to some additional ideas
The top performing stocks in the long portfolio for the month included Macy's (NYSE:M, up 20.2%), Bucyrus International (NasdaqGS:BUCY, up 19.4%) and Seagate Technology (NasdaqGS:STX, up 19.2%). The worst stocks in the long portfolio included Scripps Network Interactive (NYSE:SNI, down 7.3%), Gannett Co. (NYSE:GCI, down 6.2%) and BMC Software (NYSE:BMC, down 4.7%). A common theme among the worst performing long ideas was that there was at least one sell-side forecast implying a potential decline in ROIC moving forward. We would point out that SNI seems to share a similar trait to M -- good numbers forward and back, and apparently surrounded by extremely negative sentiment.
The top performing stocks in the short portfolio included Centrais Electricas Brasileiras S.A. (NYSE:EBR.B, down 11.4%), Hertz Global Holdings (NYSE:HTZ, down 9.3%) and Daimler AG (NYSE:DAI, down 8.7%). The worst stocks in the short portfolio included United States Steel Corp. (NYSE:X, up 19.2%), Affiliated Managers Group (NYSE:AMG, up 17.4%) and Kansas City Southern (NYSE:KSU, up 15.5%). A common theme among the worst performing short ideas was that forward-looking ROE were improving, as implied by consensus estimates. Yet one of the best performing short ideas in February (HTZ) also shows forward looking improvements in ROIC. Either the model is capturing noise, or perhaps HTZ deserves a closer look as a potential contrarian idea.
Since "inception". A dynamic long/short model portfolio since "inception" on 12/31/2004 -- excluding any taxes, slippage and commissions -- has generated a cumulative return of 201.50% versus negative 6.7% for the S&P 500 (excluding dividends) over the same period. (This return figure corrects a typo made in a previous report). The returns generated assume the ability to purchase and sell stocks on monthly closing prices (possible with some services that prime brokerages offer), and include very wide intra-month stop loss rules. A market neutral portfolio has generated a 141.15% return over the same period.
A word on stop loss rules. We think technically driven stop loss rules would be very helpful for use in this model portfolio. But one has to recognize stop losses can cap returns as well as protect against heavy losses. For example, the surge in AIG triggered our very broad stop loss rules in the model, but this ultimately hurt performance. The same rules have enhanced portfolio returns in months with more extreme volatility.
Mixed economic signals continue, with some basis for optimism. Volatility in the month was driven by conflicting domestic economic indicators and sharp swings in sentiment regarding the fallout of high sovereign debt levels in Greece and other countries. The accompanying weakening of the Euro relative to the Dollar and Yen may be causing additional consternation among equity investors.
Negatives seen in economic indicators were higher than expected jobless claims during the month, several reports of lower than expected consumer confidence indices, and a decrease in existing home sales.
On the positive side, an index showed expanding manufacturing output, a vast majority of reporting companies in the S&P 500 index beat estimates, CPI rose less than expected, GDP was revised up, the Federal Reserve indicated it would keep interest rates low even while raising the discount rate, and earlier in the month a report showed that pending home sales increased.
Currencies may point toward further weakness. With regards to currencies, some see a trend in the relatively weakening Euro as propensity of investors to reduce risk -- i.e., sell stocks. In addition, a relatively stronger dollar with little pickup in the domestic economy could point to lower domestic reported corporate earnings as international earnings are translated into U.S. reported earnings.
Model portfolio enters March net long despite mixed economic picture. The model portfolio enters March 2010 in a 120% long position and 80% short position, after being short for the entirety of February. Given the numerous missed forecasts of very intelligent and highly opinionated economists, we remain comfortable with a simple technical strategy that determines long/short portfolio weights for the model. We will miss some upside on key inflection points, but by being flexible and capturing the overall trend we believe the overall performance should do very well on average.
The model long portfolio has a huge overweight position in Consumer Discretionary and Financial stocks, but has not found anything of value in the Energy, Telecom Services or Utilities Sectors. The model short portfolio also has significant overweighted positions in Consumer Discretionary, Materials, Energy and Utilities. The portfolio underperformed largely in part due to its overweighted short positions in Materials and Energy, but two months ago the same allocations drove outperformance. If the global economies do improve, look for these "low quality" material stocks to outperform significantly once again.
13 "high-quality" stocks in the model long portfolio for March 2010 deserve close attention. The model long portfolio is composed of 40 stocks for March. These include ROST, GCI, BIG, ESI, M, DLTR, DV, MAT, HAS, SNI, SBUX, WYN, TGT, CRESY, KOF, TSN, NTY, NLY, BFR, BMA, FITB, BAP, SAN, AMP, NYB, TRV, PCL, ABC, GILD, NVO, OSK, LLL, IBM, STX, JBL, V, LZ, FCX, SMG and BVN.
Of these, there are 13 stocks that deserve a particular focus because they show a good chance for sustained operating momentum and are new to the list. These include BIG, MAT, TGT, CRESY, TSN, NTY, BFR, BMA, SAN, AMP, OSK, V, SMG.
Nine "low-quality" stocks in the model short portfolio for March 2010 deserve a closer look. The model short portfolio is composed of 53 stocks for March. These include LINT.A, IGT, CCL, ANF, MGM, WYNN, HOG, PHM, TOL, AVP, BRFS, BG, NBR, PDE, ACI, WFT, SUN, VLO, SU, BJS, ETFC, HBC, AV, REG, BK, JOE, PUK, LAZ, GENZ, PWR, HTZ, TXT, BRCD, ALU, TRMB, ERTS, AGU, RS, GGB, STLD, POT, MOS, MT, NUE, X, USM, FPL, SCG, SO, [POM, FE, TAC, SRE. We would point out once again that the "low quality" material stocks could show significant price appreciation if sentiment for an improved global economic recovery gains traction.
Of these "low quality" stock ideas, there are nine that deserve a particular focus because they are new to the list and show a good chance for sustained operating weakness. These include CCL, TOL, NBR, PDE, SUN, PUK, GENZ, TXT and USM. Investors may want to focus on some of these stocks as potentially good "contrarian" long ideas as well.
"Contrarian" investing and recognizing price momentum. We note, as always, that it is always the correctly called ideas that will show the best performance to the upside. For example, we know of a few smart people betting on a resurgence in Carnival Corp. (CCL). We would also note that the CCL stock price is going the "wrong way" for a short idea. This could mean one of two things (or sometimes both): 1) the market is dumb; or 2) perhaps there is something going on with the company that our factors are not picking up. It is important for fundamental analysts to recognize that a stock price moving the wrong way could indicate that there is information about the stock that he or she is missing.