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The markets went on a wild ride during the week ended May 14, with the S&P 500 opening Monday with a 4.40% gain and hitting a 5.47% cumulative gain by Wednesday, only to settle back down for a cumulative 2.23% gain by the close on Friday. The Russell 3000 ended the week up 2.73%.

It was another great week to be long "low-quality" stocks, with the 19 new stocks on that list surging by 3.86% on average. In contrast, the 16 "high-quality" stocks on our list appreciated by an average of 2.09%.

The four "low-quality" focus list stocks were up even higher at 5.83% and the six "high-quality" focus list stocks were up 3.01%. Focus list stocks embed several additional forward looking factors.

Once again, these moves are in keeping with trends that have for the most part been in place since March 2009 -- "low-quality" stocks tend to move higher than "high-quality" stocks on market upswings, and they tend to decline more on downswings.

Despite Market Rally, Sovereign Debt Fears Persist

A $1 trillion loan package and a bond purchase program by the EU announced prior to the market open on May 10 drove a global short-covering rally, as described above.

The more optimistic among commentators pointed out that the "shock and awe" display of fortitude would placate investors with the implication that the EU would defend its unity and currency to the utmost. The more sanguine noted that the debt-laden EU bailout of Greece was akin to moving out of the fire and into the oven -- that nothing had been done to fix the underlying structural problems that led to the reckless buildup of sovereign debt, and that backstopping with additional debt would only exacerbate the problem and eventually lead to a disintegration with the EU.

All through this, there are those that maintain that whatever happens in Europe is irrelevant to the US economy, since companies are flush with cash, improving their returns on capital, and other indicators like unemployment seem to be improving. And another interesting point of view is that it is up to the "saneness of crowds" -- that mass psychology will be the simple determination if sovereign debt fears perpetuate themselves.

We are of the opinion that none of the underlying structural issues in Europe have been solved, and it is unwise to think that an unstable European Union would have no an impact on US corporate profits and decision making. A large portion of US earnings are generated from the EU; this could negatively impact real earnings growth and translated earnings as the euro gets weaker. If the markets remain volatile or decline, this could be the impetus for delaying additional hiring decisions or other activities, like M&A transactions or equity offerings. If our opinion turns out to be wrong, we will let our technical indicators help dig us out of any hole we have made for ourselves.

Our Model Portfolios Remain Short and Unhedged, for Now

The focus list stocks and new stocks in this weekly report can be thought of as "hypothetical" updates to our model portfolios. We update the list of stocks in our model portfolios monthly, though retain the option of changing the long and short weights at any time during the month.

On May 6 at the market open we went net short in our model portfolios and advised to those not following our models to take risk off the table, including going to all cash. On May 7 we closed out all of our long positions in the models, leaving us completely unhedged and exposed from the short side. Our decisions were guided by our fundamental quant and technical models, and justified by our own judgment. We read the newspapers as much as anyone else, and we saw nothing that would cause us to override the indicators in our models.

We were already up nearly 10% relative to the index on May 7, and we thought the risk/reward on an estimated 5% rally/30% downside justified our net short position. Obviously we were wrong in the short term, but still, we have not covered the short positions in the model. This is because we think the markets have a good chance of heading lower before they move higher again. In the meanwhile, we are studying various scenarios in which we would be justified in rehedging our positions.

Our model portfolios, which unlike the "focus list" in this report, are updated monthly with a new list of stocks. At any given day during the month, the model portfolios are either net long or net short. Our aggressive portfolio is down 3.49% for the month to date (down from a peak of 1.79% on May 7, 2010 and up from a low of -8.04% on May 12), our moderate portfolio is down 0.77% (down from a peak of 3.48% on May 7 and up from a low of -4.54% on May 12) and a market neutral portfolio is up 1.17%. This compares to a 4.30% decline in the S&P 500 for the month to date (which hit a low of -6.39% on May 7).

A table detailing the returns of our model portfolio strategies is at the bottom of this report.

New stocks for the Week, May 14 to May 21, 2010

As of the close of May 14, 2010, there are 11 new "high-quality" stock ideas, four of which make our focus list. There are also 11 new "low-quality" stock ideas, three of which make our focus list. Once again, if recent trend continue "low-quality" stocks may lead the overall market up or down. In a more stable market, low-quality stocks would expect to underperform high quality.

New "high-quality" stocks relative to last week include TRW Automotive Holdings Corp. (NYSE:TRW), Hershey Co. (NYSE:HSY), Chimera Investment Corporation (NYSE:CIM), Prudential Financial, Inc. (NYSE:PRU), Rayonier Inc. (NYSE:RYN), American Financial Inc., (NYSE:AFG), Banco Santander-Chile (NYSE:SAN), East West Bancorp, Inc. (NASDAQ:EWBC), Taiwan Semiconductor Manufacturing Co. Ltd. (NYSE:TSM), LG Display Co., Ltd. (NYSE:LPL), and Telecom Argentina S A (NYSE:TEO).

Of these, TRW, EWBC, LPL and TEO make the "focus list" since a number of additional forward looking factors look favorable.

New "low-quality" stocks include Bunge Ltd. (NYSE:BG), TransCanada Corp. (NYSE:TRP), CNX Gas Corporation (CXG), Pengrowth Energy Trust (NYSE:PGH), Nasdaq OMX Group Inc. (NASDAQ:NDAQ), Mitsubishi UFJ Financial Group, Inc. (NYSE:MTU), OSI Pharmaceuticals Inc. (OSIP), Randgold Resources Ltd. (NASDAQ:GOLD), Dominion Resources, Inc. (NYSE:D), Pepco Holdings, Inc. (NYSE:POM), Alliant Energy Corporation (NYSE:LNT).

Of these TRP, GOLD and D make the focus list.

High Quality Stocks Off the "Buy List"

Strayer Education Inc. (NASDAQ:STRA), DeVry, Inc. (NYSE:DV), Tupperware Brands Corporation (NYSE:TUP), Coca-Cola FEMSA S.A.B de CV (NYSE:KOF), United Microelectronics Corporation (NYSE:UMC), Maxim Integrated Products Inc. (NASDAQ:MXIM), International Paper Co. (NYSE:IP), AptarGroup, Inc. (NYSE:ATR) and NRG Energy, Inc. (NYSE:NRG).

Low Quality Stocks Off the "Sell List"

Toyota Motor Corp. (NYSE:TM), Petrohawk Energy Corporation (NYSE:HK), Baytex Energy Trust (NYSE:BTE), Canadian Natural Resources Limited (NYSE:CNQ), Penn West Energy Trust (NYSE:PWE), Suncor Energy Inc. (NYSE:SU), Comerica Incorporated (NYSE:CMA), Regency Centers Corporation (NYSE:REG), Camden Property Trust (NYSE:CPT), ProLogis (NYSE:PLD), Robert Half International Inc. (NYSE:RHI), Activision Blizzard, Inc. (NASDAQ:ATVI), Fibria Celulose SA (NYSE:FBR), Gerdau S.A. (NYSE:GGB) and SCANA Corp. (NYSE:SCG).

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.

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

"Low-Quality Stocks Off the" Sell List"

Weekly-Low-Quality-Stocks-Off-Sell-List-2010-05-14
(Click to enlarge)

Weekly-Low-Quality-Performance-2010-05-14
(Click to enlarge)

Disclosure: No positions

Source: Focus List Update: Portfolios Remain Short and Unhedged