Focus List Update: This Rally Has Legs Until It Doesn't

Includes: AVT, BEN, LEA, SPY
by: Stephen Castellano

October 2010 was another strong month for equities, with the S&P 500 up 3.80% (3.69% without dividends) and "high-quality" stock picking strategies such as this long model portfolio doing considerably better.

Expectations for massive quantitative easing and an overwhelming win by Republicans have been cited for driving these markets. Expectations for increasing the supply of money may be driving returns of energy and material stocks, as described in an October 29 Wall Street Journal article, and a Republican friendly government may lead to more business friendly policies.

So then, what can explain the surge in the "high-quality" Consumer Discretionary, Financial and Technology stocks that we held for most of October -- stocks like Lear Corp (NYSE:LEA), to Franklin Resources (NYSE:BEN), to Avnet Inc. (NYSE:AVT)?

Perhaps there may be something else besides expectations for quantitative easing and a Republican victory that is driving the positive market action -- company specific fundamentals.

At the end of August, we found 49 "high-quality" stocks that met our criteria for purchase and 39 "low-quality" stocks at the other end of the spectrum. At the end of October, we found 59 "high-quality" stocks and 30 "low-quality" stocks. The number of stocks with poor fundamental traits and low analyst expectations are declining sharply while the number of stocks with positive fundamentals and analyst expectations is rising significantly. As a result, we will be purchasing 23 stocks on November 1 for our model portfolio, which is above the 22-stock long-term average and above the 18 stocks held in our portfolio last month.

A lot of investors are anticipating a pullback soon, perhaps following the November 2 election results or the Federal Open Market Committee meeting on November 3. This view makes sense -- the S&P 500 has appreciated in the double-digits over the last two months and a number of fully invested strategies have more than doubled than this. The staggering returns over the last two months seem a bit abnormal.

But while company fundamentals are drastically improving, "low-quality" stocks have appreciated less than "high-quality" -- it has been a strangely disciplined march upward these last two months. What if the elections and Fed signal the all clear for uncertainty in the short term? We might see a temporary but huge rally in "low-quality" stocks that rushes to fill the recent performance gap relative to their sturdier "high-quality" brethren.

Whatever happens in the markets this November 2010, a keen focus on purchasing the highest quality stocks available -- which we define as having high ranks for 1) Operating Momentum; 2) Relative Value; 3) Analyst Revision Momentum; and 4) Fundamental Quality -- and managing such a portfolio with disciplined risk management should remain a prudent strategy.

Disclosure: Author long LEA, BEN and AVT