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This Short Covering Rally May Get Fundamental Legs

For the month to date the average returns of "low-quality" stocks in our theoretical portfolios have drastically outperformed returns of "high-quality" stocks (+11.49% vs. 5.23%, respectively).

Recent price movements in "low-quality" stocks suggests that the prevailing market sentiment for perpetual negative estimate revisions could now be over, and once again discounting long-term improvements in fundamentals.

If the market stays flat or moves slightly higher for another two trading days, our models will likely assume long positions in these "low-quality" stocks vs. previously held short positions.

The last time our models assumed long positions in low-quality stocks was July 2009, providing a theoretical ~+20% return vs. +5.8% in the S&P 500 over 12 trading days.

A short covering rally may turn into a fundamental-driven rally soon
"Low-quality" stocks in our model portfolio have been drastically outperforming "high-quality" stocks since October 1, 2015. As a result, our theoretical short model portfolio has experience a number of stop losses and actual hedge funds are probably experiencing the same. While this rally may have initially been technical in nature and driven by short covering, it increasingly seems likely to become driven more by positive fundamental sentiment.

(We define low-quality as: 1) poor relative value, 2) poor operating momentum, 3) negative consensus estimate revisions, 4) poor fundamental quality. For more information on our definitions of quality, please see our most recent prior portfolio model report, "24 Stocks for October 2015."

For much of September, the prevailing market sentiment seemed to be that recent negative estimate revisions would be...


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