Thinking About This Week's Market: Chaos and Crisis

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Includes: AGO, AIG, BNO, EEM, GULF, MBI, NFLX, OIL, VXX
by: Mercenary Trader

by Mike McDermott

As we strap into the turret for another week of trading, the Middle East crisis continues to take center stage. In Libya, Moammar Gaddaffi continues to cling to power, even as the opposition expands their area of control. Saudi Arabia has indicated they will step up production to meet any supply disruptions from Libya, meanwhile oil prices are hovering near triple digits.

Last week was shortened by US market holiday, but that didn’t stop the market from logging its largest weekly decline in roughly three months. A brief rally on Friday, helped to ease the anxiety levels, in many cases the technical damage is done. The trading environment feels very precarious with plenty of risk and uncertainty.

Heading into the week, Mercenary portfolios are net short with only moderate gross exposure. Historically, major market turns are always a bit tricky to time, and while we are closely tracking the financial and political risks, we’ve got a good bit of dry powder to use as individual sectors begin to confirm a complete bearish reversal.

After a brief respite, a break of low points logged Thursday could offer just the right catalyst for committing more capital. Rather than making a significant commitment to the first move of a large market shift, our approach is to make a few initial forays with limited capital – and then bring out the heavy guns once the trend has been confirmed.

On the other hand, if the resilient bulls pull another Houdini act and manage to support prices, we will suffer a few nicks while keeping the majority of our risk capital protected. It’s all part of the “stick-and-move” trading process as we jockey for position and wait for the best opportunities to lean heavily into a trade.

This week could offer a key inflection point for the bears. If it does, we’ll be ready with a number of chances to add horizontal and vertical exposure.

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Elevated risk in the broad economy, means significantly more risk for the insurance companies responsible for protecting investors.

We have had our eye on financial insurers such as American International Group (NYSE:AIG), Assured Guarantee (NYSE:AGO) and MBIA Inc. (NYSE:MBI) for a number of months.

Late in 2010, investors got excited as litigation surrounding failed mortgage securities offered the insurance companies some recourse, while still being light enough to keep the major underwriters out of hot water. But while the insurers may have escaped this area of crisis with minor injuries, the companies now face mounting risk with municipal bonds.

As state and local governments struggle to balance budgets, the muni market is becoming more dangerous. Of course this is bad news for the firms insuring these municipal bonds – firms that could be on the hook for hundreds of millions, or even billions, if municipalities are forced to default.

Last week, AIG clearly broke a new support level and confirmed its topping pattern. Investors were unimpressed with the company’s earnings report and we were able to use the weakness to establish a new short position. Click to enlarge:

As AIG confirms its downtrend, we will be automatically tightening our risk points and looking for opportunities to take profits on weakness. New inflection points may also give us chances to pyramid into more exposure swinging for an extra-base hit as our P&L gives us the green light to be more aggressive.

Volatility Back in Play

The last few months have been relentless in terms of a slow-steady grind higher.

  • Expanding European debt crisis?? No worries, the US market can handle it…
  • Rising food costs?? That’s an Emerging Market problem – all good here…
  • Falling Home Prices?? We’ve heard that story plenty of times before…
  • Stubborn Unemployment?? Not if you believe the headline statistics…

The CBOE Volatility Index (VIX) is a great tool for measuring the complacency of investors. Lower levels on the VIX indicates low implied volatility – or low expectations for volatility.

Last week’s action began a significant shift in perceived risk for the market. As institutional investors begin to feel less comfortable with their positions, they will step up hedging activity (as well as cutting exposure to risky positions).

Picking up exposure to the iPath S&P 500 VIX Short-Term (NYSEARCA:VXX) could offer quick profits as bullish investors are caught leaning the wrong way – and scramble to cope with rising levels of risk. Click to enlarge:

Emerging Markets On the Ropes

Higher energy costs and geopolitical tensions are especially troubling for emerging markets. Many of these economies lack the efficiencies or energy alternatives enjoyed by developed nations. So when oil prices spike, or supplies are disrupted, it wreaks havoc on the vulnerable economies.

Similarly, emerging markets rely heavily on a delicate balance of imports and exports. As political tensions rise and consumers across the globe react to higher levels of risk, these distribution channels can be called into question – leading to lower output and economic strain.

Emerging markets as a group have already begun to show weakness. Higher food and housing costs were the primary challenges in 2010. This year it looks like energy costs will be added to the mix. Click to enlarge:

The broad emerging market index offers a good picture of the environment we are dealing with. From a more tactical trading perspective, the Mercenary Portfolios are taking individual short positions – focusing on specific countries and asset classes within the emerging market group.

Many of the individual country ETFs – or those offering exposure to small-cap stocks within specific emerging markets have already triggered inflection points and generated short trades. We are actively monitoring our risk points here and have already taken half profits on at least three emerging market related short positions.

Cult Stocks Falling out of Favor

Last week, Bespoke compiled an interesting report titled What Has Been Moving Shares Lower?

The report identified a number of key issues responsible for (or at least correlated to) the falling stock prices. As a general rule,

  • Small-cap names are more vulnerable than large-cap.
  • High valuation names are more vulnerable than cheap stocks.
  • Dividend yields have offered price support.
  • High institutional ownership is a negative factor.

This is particularly interesting for the group of stocks we often refer to as “cult-stocks” – the over-owned, over-loved, high-priced growth darlings of Wall Street.

Last week we took a short position in Netflix Inc. (NASDAQ:NFLX) after the expensive growth stock hit an all-time high – only to be met with heavy selling pressure. Click to enlarge:

Fundamentally, the company is facing new competition and growth expectations are being called into question. Technically, the stock has become overbought, and has likely trapped new bulls who bought on the breakout.

A violation of the 50 EMA (red line) would likely trigger additional sell orders as momentum traders often use this as a dividing line for bullish and bearish setups.

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