Sharp Rally In Low-Quality Stocks Points To Ongoing Market Gains

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Includes: AEO, CHK, DXC, FCX, JBLU, LOW, MRO, NVDA
by: Stephen Castellano

Summary

In just the first four trading days of March 2016, the low-quality stocks in our theoretical Core Short Model portfolio have surged 8.39% and triggered a stop loss signal.

Four out of the last five rallies that were strong enough to trigger a stop-loss in our short model portfolio preceded rallies that lasted the balance of the month.

Anecdotal data points, together with this low-quality rally, support the idea we are at the cusp of another sustained rally for the balance of March 2016.

We suggest long-term investors overweight positions in high-quality stocks, and short-term investors and traders adopt a positive bias.

For the month to date of March 2016, low-quality stock returns from our March 2016 model portfolio report have surged, setting up what we think is a strong likelihood of an ongoing market rally through month's end. For a primer of how we define low-quality stocks, see the introduction of our September 2015 report.

In just the first four trading days of this month, the low-quality stocks in our theoretical Core Short Model portfolio have surged 8.39% (for the equivalent assumed short sale loss). In contrast, the high-quality stocks in our theoretical Core Long Model portfolio have only moved up 3.63%. This surge in low-quality stocks triggered a move to 100% cash in our Opportunistic Short Model portfolio on March 3.

Since October 2010, four out of five rallies in low-quality stocks that have been sharp enough to trigger a stop loss signal in our theoretical short sale model have preceded sustained market rallies for the balance of the month. In the last such rally, high-quality stocks performed exceptionally well. In the last two of these five rallies, the Volatility Index has declined significantly.

In summary, we think there is a good chance that the market will continue to rally for the balance of March 2016, and there is also a good chance that high-quality stocks could significantly improve, and that the Volatility Index could significantly decline.

Below is an overview of returns of the most recent low-quality stock rally, and the five preceding low-quality stock rallies going back to October 2011.

March 2016 Low-Quality Market Rally
The tables below present the month-to-date returns of our theoretical long/short model portfolio report, 21 Stocks for March 2016. The rows highlighted in red indicate the date of a stop loss trigger in our Opportunistic model portfolio.

The first table shows theoretical returns for our Core Long/Short Model portfolio, which does not utilize a cash allocation model. The return figures indicate that low-quality stocks in our short model portfolio have drastically outperformed the high-quality stocks in our long model portfolio, as well as the S&P 500. The net effect is a -4.76% long/short theoretical loss for the month to date as of March 4, 2016.

The next table indicates returns for our theoretical Opportunistic Long/Short Model theoretical model portfolio. This model is composed of the same basket of stocks as the one above, but additionally takes into account a cash allocation model. The Opportunistic model assumed a 100% cash position just prior to the close on March 3, 2016. The net effect is a -3.07% long/short theoretical loss for the month to date.

October 2015 Low-Quality Stock Rally
After low-quality stock returns in our model surged by 7.85% over the first three trading days of the month ended October 5, 2015, high-quality stocks moved another 7.31% higher for the rest of October and low-quality stocks moved another 4.99% higher.

The S&P 500, which was already up 3.10% by October 6, 2015, improved by another 4.95% over the rest of the month. The Volatility Index declined by 22.88%, 19.54 on October 5 to 15.07 on October 30.

The first red bar indicates when the accompanying Opportunistic Short Model experienced a portfolio-wide stop loss trigger. The second red bar just highlights the end of month data, which we use to calculate the returns following the stop loss.

February 2015 Low-Quality Stock Rally
Low-quality stock returns in our theoretical portfolio model surged by 7.80% over the first nine trading days of the month ending February 12, 2015, and triggered a stop loss in the Opportunistic version of the short model portfolio.

For the balance of the month, high-quality stocks moved 1.87% higher and low-quality stocks moved 1.47% higher. The S&P 500, which was up by 4.62% on February 12, 2015, moved another 0.77% higher to finish the month with a 5.38% simple cumulative return gain. The Volatility Index declined by 13.40% to 13.34 over this same period.

September 2013 Low-Quality Stock Rally
In September 2013, low-quality stock returns in our theoretical short model portfolio increased by 6.49% before triggering a stop loss signal in the Opportunistic model portfolio on September 10, 2013.

Returns of these low-quality stocks ended the month another 0.64% for the rest of the month for a simple cumulative theoretical return of 7.13%. High-quality stocks moved another 1.47% higher for the balance of the month to finish up 5.53%. In contrast, over this September 11-30, 2013 period, the S&P 500 declined by 0.13% and the VIX increased by 14.25%.

While this low-quality stock rally was not followed by meaningfully subsequent gains, returns did end the month up slightly higher.

July 2013 Low-Quality Stock Rally and Subsequent Returns
During this period, low-quality stocks in our short model portfolio increased by 5.54% before triggering a stop loss signal on July 15, 2013. In this case, stock returns in the theoretical model ended July 31 roughly unchanged relative to July 15.

October 2011 Low-Quality Stock Rally
During October 2011, low-quality stocks in our model increased by 6.95% before triggering a stop loss signal on October 13, 2011, in the Opportunistic model. This same basket of stocks finished the month up another 6.63% ending the month with a simple cumulative return of 13.58%. The basket of high-quality stocks, which was already up 14.18% on October 13, 2011, moved another 7.51% higher for a theoretical simple cumulative return of 21.68%. The S&P 500, which had posted a 6.35% return for the month as of October 13, 2011, finished the month up 10.60%.

Low-Quality Stock Rallies from December 2005 to December 2010
Our model portfolio strategies recorded participation in a number of low-quality rallies between its March 31, 2009, inception and December 31, 2010, which triggered a stop loss in our low-quality short sale model portfolios. In all of these cases, overall returns for high-quality stocks, low quality stocks and the S&P 500 ended the month slightly above or below the cumulative return that triggered the stop loss. For the backtest period going back to December 31, 2005, the models experienced no low-quality stock rallies that were significant enough to trigger a short sale model portfolio stop loss.

Anecdotal evidence supports optimism for an ongoing March 2016 rally
Signals and rules tend to work… until they don't. In this most recent case, we are very bullish on the likelihood that we have seen a valid signal with the surge in low-quality stocks for sustained ongoing gains in all types of stocks through the rest of March. We think high-quality stocks will do particularly well as investors rotate out of low-quality and seek returns elsewhere.

Several key anecdotal points that support optimism for a near-term face ripping rally:

  • WTI oil has rallied and broken through the most recent highs, perhaps indicating strong underlying economic demand.
  • Other commodity prices like steel, copper, and aluminum are also increasing above most recent highs.
  • The U.S. dollar has weakened in recent months and seems to be flattening relative to years of seemingly inexorable strength. If the USD has bottomed, this would reduce the threat of imports and improve reported U.S. company-reported earnings.
  • The S&P 500 has moved up close to a key technical inflection point, which likely belies a sharp move in either direction in the near term.

Summary and Suggestions
For the balance of March 2016, we suggest investors adopt a positive bias on all U.S. stocks and indices, and overweight positions in high-quality stocks.

In our opinion, long-term investors should focus on high-quality stocks and not chase low-quality at this point. Our favorite long-term plays continue to be Lowe's Companies (NYSE:LOW) and NVIDIA Corp (NASDAQ:NVDA). There is plenty of room for these high-quality stocks to rally both in the short-term and near term.

In our opinion, traders should continue keeping an eye on sharply rallying, highly liquid, low-quality stocks such as Chesapeake Energy Corporation (NYSE:CHK), Marathon Oil Corporation (NYSE:MRO), and Freeport-McMoRan, Inc. (NYSE:FCX).

But we think there is chance for better upside for the balance of the month in high-quality stocks such as Cisco Systems Inc. (NASDAQ:CSCO), NVIDIA Corp., JetBlue Airways Corp. (NASDAQ:JBLU), Lowe's Companies, and American Eagle Outfitters (NYSE:AEO). All five are in our theoretical long model portfolio of high-quality stocks, and each has average daily trading volume of more than 6m. Of these five, American Eagle Outfitters and JetBlue have the highest recent price volatility.

Month-to-date returns of stocks in the long and short model portfolios

The theoretical long model portfolios are composed of identical baskets of high-quality stocks.

The theoretical short model portfolios are composed of identical baskets of low-quality stocks.

Supporting Documents

  1. Intra-Month-Update-Ascendere-2016-03-06.pdf

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in ALL OF THE STOCKS MENTIONED IN THIS REPORT over the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: There are limitations inherent in our theoretical model results, particularly with the fact that such results do not represent actual trading and they may not reflect the impact material economic and market factors might have had on our decision making if we were actually managing client money. Please see additional disclaimers and disclosures at the back of this report.