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by Mike McDermott

After a relentless period of bullish action – and the lowest volatility seen since pre-financial crisis days, last week’s action indicates that the bears may still have a pulse. (However, the Chicago Bears can now settle back and rest up for next year…)

So many cautions investors have finally capitulated, casting reservations aside and re-entering the market. We’re now left with a situation where the majority of participants are holding net long exposure, and both professional and individual sentiment has reached extreme levels.

LOLO managers (long-only-leveraged-outright) have piled their plates high with speculative, high-beta positions. Retail investors are finally feeling comfortable to wade back in to equities. And of course the trend followers have had nothing but buy signals on their radar for the last three months.

Last week we noted this “crowded theater” market environment, pointing out that the situation was ripe for someone to yell “fire!

Our focus was largely on the crowded precious metal area along with deteriorating conditions for retail stocks. Both of these industry groups came under pressure leading to a profitable week for the Mercenary Portfolios.

This week we continue to roll with what is working, along with some over-owned “cult stocks” and momentum darlings that have simply run out of gas.

With earnings season now fully upon us, there are plenty of cross currents in the works. We’re staying nimble and keeping some bullish names on the radar too (a balanced portfolio allows for success in gyrating markets while helping to reduce volatility). But considering the long period of smooth sailing, and the bearish start to earnings season, it may be a few weeks before the dip buyers can muster their courage and step back in.

So let’s take a look at this week’s landscape…

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Retail Strength: We Just Don’t Buy It

A number of key retail stocks - from apparel to department stores to specialty niche – have recently come under pressure. The weakness started with companies that catered to the lower-income demographic who are finding it difficult to secure employment and cope with rising living expenses.

More recently, the negative action has affected middle class and high end retailers. And as our screens trigger more short opportunities, the Mercenary portfolios are picking up bearish exposure.

Last Tuesday morning (after the MLK Jr. market holiday) the Mercenary Live Feed noted an attractive setup for Deckers Outdoor Corp. (NYSE:DECK). The stock had broken a strong bullish trend in late December and had spent two weeks consolidating its initial correction.

The company had a tremendous year in 2010, with earnings growing by 25%, and growing quarterly sales figures. But with growth set to taper off, and a price multiple above the industry norm, DECK was certainly vulnerable.

It took a bit longer than expected, but the retail group is beginning to turn south, and with it many of the over-loved and over-owned household name stocks. Live Feed members entered the short trade on the following day as DECK traded through our entry point and continued to weaken throughout the week.

The position is now showing profit of about 1.2 R (1.2 times initial capital at risk) and will likely continue to drop as the retail sector gains bearish momentum. We’re continuing to tighten risk points in DECK and our other bearish retail plays as negative trend lines are beginning to show up (click to enlarge).

Cloud Concerns Mount

Cloud technology has been the “dot-com” scenario for 2010. From a business standpoint, the products being offered are simply tremendous. Customers are able to increase productivity, securely store and access information, and collaborate across time zones and geographic locations. And the Software-As-A-Service (SAAS) makes the technology available and affordable to a much wider base of customers.

But as Barron’s mentioned this weekend, “the market for cloud computing is as competitive as it is sexy.”

F5 Networks (NASDAQ:FFIV) shook up the group Thursday when the company announced earnings that were in line with estimates – along with guidance that simply met consensus forecasts. Since the entire industry has conditioned investors to expect earnings beats and raised guidance, the ho-hum report was met with a sharp 25% drop in the stock (click to enlarge).

We’ve had our eye on Salesforce.com (NYSE:CRM) for some time now, as the stock trades at a stratospheric multiple with the potential for significant contraction in its growth level.

As with most “cult” momentum stocks, the madness can continue for much longer than expected, and any short-term price corrections have been met by excited dip-buyers. It doesn’t pay to fight this trend, but once the run is exhausted, the short trade offers tremendous opportunity.

The Barron’s piece brought up some interesting accusations when it comes to the company’s “reported” (read: adjusted) earnings as compared to the standard GAAP earnings. The company adjusts to take out option expenses which are significant considering the rate at which options are awarded for executive and employee compensation. Even using the “reported” earnings, CRM trades at a dangerous level. But accounting for these true, legitimate expenses – the bearish potential becomes even greater.

We’re not eager to step into this name immediately, as the dip buyers may give it one last try. But the sharp gap lower and the confirmation across the industry makes this stock (and the entire group) worth watching closely as potential trades for later this week (click to enlarge).

Restaurants Still in the Crosshairs

Over the weekend, Yahoo Finance rolled with a front-page article titled: American Fast Food: From Supersize to Downsized. The article (along with a cheesy – no pun intended – video) discusses some of the challenges major restaurant chains are facing.

While consumer spending may be rising in aggregate, the lower tier of workers / spenders are still struggling with a difficult environment. This makes it very challenging to operate profitable franchises and adds to our bearish quick-service-restaurant thesis.

Of course in addition to a challenged lower-end consumer, rising commodity prices are crimping margins which is another challenge entirely.

Chipotle Mexican Grill (NYSE:CMG) should see contracting margins as their higher-end fare is a stretch for consumers – not to mention the effect of higher costs. Since the company is committed to organic and higher quality food, rising commodity costs are even more dangerous.

So after a period of very impressive growth, investors are finally realizing that there is more risk to the long-term expansion picture – and at 33 times future (and optimistic) expectations, the stock price is quite vulnerable (click to enlarge).

Welcome Back Volatility

After several months of steady, peaceful bullish action, it’s easy to forget what a dangerous market feels like. In fact, the flash crash of 2010 has faded into a distant memory with few people paying more than lip service to the dangers of high-frequency trading computers or unexpected market routs.

Of course, if the bearish action picks up – volatility will rise alongside, and that includes option premiums as measured by the VIX or CBOE Volatility Index (VIX) (click to enlarge).

Today’s trading tools may include dangerous HFT computers, but also offers some interesting vehicles to help hedge or profit from the risk of increased market gyrations.

The iPath VIX Short-Term Futures ETN (NYSEARCA:VXX) offers a great trading vehicle for profiting from a jump in volatility. From an investment perspective, we know the vehicle is flawed (so hold the comments please). But from a trading perspective it can offer tremendous opportunity such as the 100% ramp between April and May 2010 when the market last experienced a major correction.

This young bear-cub market could turn out to be a snarling grizzly in a few weeks time. Or it could be that bail-out-Ben and his cohorts devise another liquidity injection to pump up paper stocks. Panic could send traders for the exits, or dip buyers could grow a pair and once again step in to save the day.

Uncertainty is part of reality that we embrace as traders. But understanding probabilities and asymmetric risk metrics gives us the luxury of waiting for high-conviction periods where returns will be strong if our assumptions are correct – and risk will be contained when positions move against us.

With key speculative areas rolling over, and pricey multiples leaving plenty of room for disappointment, our bearish setups are poised for attractive gains this week.

Disclosure: As active traders, authors may have positions long or short in any securities mentioned. Full disclaimer can be found here.

Source: Bears May Still Have a Pulse