Focus List Update: EU Delivers a Possible Short Squeeze of the Century

by: Stephen Castellano

Focus List Update

The S&P 500 declined 6.39%% for the week ended May 7, 2010, and the Russell 3000 Index declined 6.82%. In contrast, new stocks on our "high-quality" list declined 7.82% and "low-quality" stocks declined 9.29%.

The seven new stocks on the weekly high-quality "focus" list, derived from additional forward-looking factors, declined by 8.74% on average. The two low-quality focus list stocks moved down by 11.06%.

These figures are in keeping with recent trends, in which we have seen "low-quality" stocks swing up and down more forcefully relative to "high-quality" stocks in the same overall direction of the market.

EU Delivers a global short squeeze of the century? Maybe so, but what happens next?
As I write this, around 11pm Sunday May 9 S&P 500 futures are up 28.40, a positive 2.57% move from Friday's close, and the Nikkei index in active trading is up 1.30%. According to Bloomberg, "European policy makers unveiled an unprecedented loan package worth almost $1 trillion and a program of bond purchases as they spearheaded a global drive to stop a sovereign-debt crisis that threatened to shatter confidence in the euro."

Admittedly we are in a bit of a conundrum - our model closed out of its long positions at the open of May 7, 2010 leaving the model portfolios completely exposed to the short side. As a result, we stand to give back the huge relative gains we have made for the month to date. Given that our models seem to generally track the actions of many other hedge funds, it could be we will see something approaching the "Short Squeeze of the Century" as they all run to cover their positions. Our Moderate model portfolio strategy is up 3.48% for the month to date, versus a decline in the S&P 500 of 6.39% - a difference of 9.87 percentage points. The Aggressive strategy is up 1.79%, or 8.18% higher than the S&P 500.

If the S&P 500 closes up 3% and our short positions hurt us by 4.5%, we will be close to back where we started at the beginning of the month or still slightly ahead relative to the index This is an unfortunate turn of events as far as our model portfolios go, but not outside of the calculated risk we were aware we were taking (we were looking for a positive EU announcement or lack thereof to drive 5% upside or 30% downside in the S&P 500). In any case, we rather make our gains on the long side and without the world descending into ash, so we are happy for the turn of events. We are also happy for some of our friends that went long on index call options on Friday based on their faith the EU would deliver over the weekend. A hearty Merry Christmas (Hanukkah, etc.) to them!

What to do next? Do we now go long and close out all of our short positions? That runs counterproductive to our model that we have based many of our decisions on, and has worked very well for us. In order for our technical indicator to roll back over to the long side, it would require the equivalent of another 5 or 6 days of 2.57% moves in the S&P 500 to do so. Perhaps that is possible, but at this particular moment, not probable.

To go back to the July 2007 anecdotal illustration we have previously mentioned - is there a chance we could be approximating the market action starting as of August 6, 2007? On that day, the S&P 500 Index closed up 2.42%, and up 0.62% and 1.41% after - a 3-day 4.45% rise that was followed by a 6.18% decline. From August 6 to August 31, the S&P 500 only appreciated by 0.43% and other pressures gradually built up until the markets plummeted.

Admittedly, this is not a forecast model or any kind of deep analysis. The economic environment is very different than compared to 2007, but the volatility is not. Even though this is just an illustration, it is an important one for it depicts that volatility, which is driven by deep underlying structural issues, does not dissipate overnight.

Given that larger fundamental problems and a debt-laden global economy is not exactly the recipe for growth, we will not rush to make knee-jerk reactions but will remain disciplined and focus on what has always worked for us -- keeping our options open and our minds flexible, as we track any changes to our long/short indicator. In any case, once our indicators do turn "green" we will be launching a real-money, auto-tradable IRA product that is based largely on our model strategies.

For those not following our strategies, this could be a great one-time tradable event. We provide a list of stocks worth choosing from below. We note that the more optimistic investors may want to go long our "low-quality" list -- these stocks have been consistently outperforming on the upside for the last several months. But be forewarned, in a down market they outperform on the downside as well.

New stocks for the week, May 7 to May 14, 2010
As of the close of May 7, 2010, there are 16 new "high-quality" stock ideas, seven of which make our focus list. There are also 15 new "low-quality" stocks, including four focus list ideas.

New "high-quality" stocks on the list this week include Strayer Education Inc. (NASDAQ:STRA), Mattel Inc. (NASDAQ:MAT), Companhia de Bebidas Das Americas (ABV), Coca-Cola FEMSA S.A.B de CV (NYSE:KOF), Credicorp Ltd. (NYSE:BAP), Ameriprise Financial Inc. (NYSE:AMP), Franklin Resources Inc. (NYSE:BEN), 3M Co. (NYSE:MMM), United Microelectronics Corporation (NYSE:UMC), Aixtron AG (NASDAQ:AIXG), Xilinx Inc. (NASDAQ:XLNX), Maxim Integrated Products Inc. (NASDAQ:MXIM), Ingram Micro Inc. (NYSE:IM), International Paper Co. (NYSE:IP), EI DuPont de Nemours & Co. (NYSE:DD), Sinopec Shanghai Petrochemical Co. Ltd. (NYSE:SHI),

Focus list ideas derived from this group include ABV, BEN, AIXG, XLNX and MXIM.

New "low-quality" ideas for the week include WPP plc (NASDAQ:WPPGY), Daimler AG (DAI), DreamWorks Animation SKG Inc. (NASDAQ:DWA), Compania Cervecerias Unidas S.A. (NYSE:CCU), BRF - Brasil Foods S.A. (NYSE:BRFS), Baytex Energy Trust (NYSE:BTE), Canadian Natural Resources Limited (NYSE:CNQ), Penn West Energy Trust (NYSE:PWE), Suncor Energy Inc. (NYSE:SU), Mack-Cali Realty Corp. (NYSE:CLI), Fibria Celulose SA (NYSE:FBR), Gerdau S.A. (NYSE:GGB), Sims Metal Management Limited (SMS), China Telecom Corp. Ltd. (NYSE:CHA), Indosat tbk PT (IIT).

Focus list ideas derived from this group include CLI, FBR, SMS and CHA.

High Quality Stocks Off the "Buy List"
Stocks moving off the "high-quality" buy list due to sharply lower analyst revisions include Tim Hortons Inc. (THI), Canadian Imperial Bank of Commerce (NYSE:CM), The Bank of Nova Scotia (NYSE:BNS) and Bank of Montreal (NYSE:BMO).

Low Quality Stocks Off the "Sell List"
Stocks moving off the "low-quality" buy list due to sharply higher analyst revisions include Sony Corporation (NYSE:SNE) and NII Holdings Inc. (NASDAQ:NIHD).

Readers should put sell side analyst revisions in context - most of the time, these recommendations are reactive rather than predictive. Sometimes they are wrong. Occasionally they are prescient, and perhaps presaging meaningful changes in the future underlying fundamentals of a company, especially if they are represent sharp directional moves. There is no one way to use and apply quantitative information -- the best team of analysts should use the underlying data and make their own decision as to what it is implying. At the same time, after providing all of that context, on average and over time, these quant models do seem to outperform various benchmarks significantly.

About the Focus List Update
Focus List Update ideas, which we have only been tracking since March 5, 2010, are generated in a similar way to the Ascendere Long/Short Model Portfolio, which rebalances roughly 100 stocks on a monthly basis. Unlike our monthly model portfolio, we have not backtested the factors in our weekly focus list, but we would not be sharing these ideas unless we thought they could show some promise on average over time. We realize the higher frequency of this strategy may be introducing some noise to the process.

Perhaps one way to cut through the noise is to compare these weekly lists with lists from other sources. For example, a number of the stocks on these weekly updates have appeared on Goldman Sachs's Conviction Lists a few days or weeks later. Domtar Corp. (NYSE:UFS) is one recent example of this. We note that some of the best names on this list have preempted a number of sell side upgrades, as described in our "Nostradamus" report, and such stocks seem to show the most promise.

A pdf of this report is available.

Risks and Disclaimers
Investing in stocks include a high degree of risk, including the risk of total loss. We are not soliciting the sale of any security. We do our best to provide relatively and accurate data and analysis, but make no guarantee.



"High-Quality" Stocks Off the "Buy List"

"Low-Quality Stocks Off the" Sell List"

Disclosure: None