There’s a lot at stake as we strap into the turret for another week of trading.
Now that earnings season is drawing to a close, investors have fewer stock-specific data points to work with and are less prone to knee-jerk reactions to minor data points. That leaves institutional desks with more time to study the macro picture and build positions based on larger, more well-defined trends.
It’s becoming more and more difficult to justify a bullish outlook based on the mounting global risks and immediate catalysts in place:
- As revolution sweeps through the Middle East, oil prices are rising – putting strain on developed and emerging nations alike.
- Spreading infection in Europe may have been put on the back burner, but euro sovereign debt risk is significant and not going away any time soon.
- Inflation (food, energy, housing etc) is threatening emerging nations and could stymie growth at a time we can ill afford any setbacks.
- The broad markets have largely priced in a recovery scenario and are relatively expensive – or vulnerable to disappointment shocks.
From a technical perspective, the last couple of weeks have featured a change in tone. Instead of a robust bull trend with little volatility, markets have begun gyrating with large swings both to the positive and negative side. Seven of the last nine sessions have included a triple-digit move for the Dow.
This type of volatile churn indicates that there is a major ongoing battle between the bulls and the bears – one which could turn the immediate tide and bring on a more substantive bear market, which incorporates many of the risks we are seeing.
There’s no guarantee that the bears are going to win this battle. Although the big picture risks are significant, we still have Bernanke & Co. doing everything possible to keep paper assets propped up and investor confidence high. Entering the week, Mercenary Portfolios hold relatively light exposure with plenty of dry powder.
We’re waiting to see a significant breakdown in price action before committing too much risk capital to the bear side. But we’ve got our finger on the pulse of some attractive setups with potential for significant trading gains if triggered.
Financials Hit the Skids
After a massive bailout (courtesy of the U.S. taxpayer) and numerous – and inefficient – stimulus measures, large-cap U.S. financial stocks have climbed back to respectable levels. But investors may not be completely aware of the mounting risks.
Shifting political sentiment is a major risk for these highly-regulated institutions. On top of political risk, banks are vulnerable to a stall in the global recovery. If inflation issues cause U.S. policymakers to raise rates in the U.S., it would constrict the banks’ access to capital and pressure profit margins.
On top of all of these issues is the lucrative business of proprietary trading – a business that is now largely off-limits for institutions that fall under FDIC jurisdiction. Banks are finding a few ways to work around the regulations, but the bottom line is that we are entering a more challenging environment for the mega-banks.
The price action looks ominous for a number of these well-known banks. A break through key support levels could set up some great trades with potential returns far outweighing the amount of capital at risk.
Bank of America (BAC) has run into resistance near $15, and has spent the majority of the year completing a wedge pattern. If the low end of this consolidation is broken, it would be natural for BAC to test it’s December low. At the same time, our trade risk could be largely contained as a sharp break would allow for a tight risk point in the mid-range of the existing consolidation.
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Morgan Stanley (MS) has already traded decidedly below a bullish trend line, and is picking up momentum on the other side. Friday’s market rout left the stock well below the 50 EMA (red line). This is likely to catch the attention of intermediate-term trend followers and may spark further selling this week.
More importantly from our perspective, Morgan Stanley offers strong evidence that the group is in fact rolling over. At Mercenary Trader, we tend to look at stocks within the context of groups – and so it is helpful to see confirmation as many names in the same sector behave in a similar fashion.
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In late February, the Mercenary Live Feed took a short position in an additional large-cap bank, as it was breaking a trend similar to the one shown above.
Friday’s bearish action was particularly helpful as we were able to add vertical exposure to the position as the stock broke through a new consolidation level. As profits begin to accumulate, we are lowering our risk point along the way – locking in gains while building a larger position. This is the type of situation where a single can quickly turn into a triple or home run – as long as the price action continues to move in our favor.
Regional Banks and Real Estate Exposure
Large-cap banks may be in the political cross-hairs, but smaller regional banks have their own set of challenges. The biggest headwind for most regional banks is exposure to real estate.
Recent Case-Shiller indications show that the housing market is NOT improving. Home prices are still declining (although the year-over-year declines are smaller percentages), and inventories of unsold homes continue to be very high.
As long as inventories of existing homes remain high, it will be very difficult for regional banks to unload their foreclosed homes – or their property holdings in various stages of development. In January, we issued a Strategic Intelligence Report outlining the bearish case for three individual banks. A look at the SPDR Regional Bank (KRE) ETF below shows that the group has run into resistance and is vulnerable.
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Cult Stocks Slip
In a bull market, the most well-loved momentum stocks can log tremendous gains as investors pile into growth stories at nearly any price. But once the music stops playing, these names can cause devastating losses as inflated prices yield to reality.
Last week, we outlined two momentum champs struggling to keep their positive trends in place.
Friday’s negative action gave us some bearish confirmation for the market in general and makes it easier to pull the trigger on new short positions in this area.
This morning, we have identified price points for entering initial short positions. As the action confirms our bearish outlook for momentum names, we will be laying out the bearish exposure and then tightening our risk points along the way. Trapped bulls could very well stampede for the exits this week – increasing volatility and giving us rapid gains.
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Emerging Market Trends
Higher oil prices are adding yet another inflationary challenge for emerging markets. China is already struggling with higher food prices and a raging real estate bubble.
One of our strongest positions right now is a bearish China real estate play that has broken down sharply. E-House China (EJ) broke through a key inflection point in February. Tighter controls on real estate transactions is challenging EJ’s business, and investors are realizing that growth will be under pressure for months to come.
At this point, subscribers to the Mercenary Live Feed have already taken half profits on this opportunity and tightened their risk point on the remaining shares. But EJ is beginning to consolidate once again, and it will be interesting to see if the stock gives us an attractive opportunity to pyramid into a larger position.
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A couple of hours before the open, futures are indicating a modestly positive start. But international markets are trading in the red with Libya continuing to make new headlines.
We’re locked and loaded with our defense tight and our eye on emerging opportunity. The stakes are high and there’s no other game I’d rather be playing.
Disclosure: As active traders, authors may have positions long or short in any securities mentioned. Full disclaimer can be found here.