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by Mike McDermott

As traders gear up for another week of action, uncertainty continues to buffet markets – leading to increasing volatility.

Over the weekend, allied forces opened fire on Libyan military installations. The goal was to cripple Gaddafi’s ability to use excessive force on protesting civilians. Of course the dictator publicly denounced “the party of Satan,” stating that the US, France and Britain were simply trying to control the nation’s oil supplies.

Political views aside, the unrest in the Middle East is certainly having a material effect on energy markets. Even before the unrest in Egypt, oil prices had been climbing. With the added ME uncertainty, governments are scrambling to secure access to alternative resources, while simultaneously weighing the big-picture fallout as political strain intensifies.

Adding to the uncertainty, Japan’s potential nuclear disaster has governments across the globe rethinking their policies on nuclear energy. It is still very early to assess the long-term repercussions. But if a significant portion of planned and existing nuclear reactors are taken offline, there will be a void in terms of electricity production for both developed and emerging economies.

Traders are in the early stages of handicapping the domino effect, and there will be plenty of opportunities to profit from energy shifts over the next several months.

On top of disruptions in the energy market, we still have significant uncertainty in several other key areas.

  • The European sovereign debt crisis continues to grow. Austerity programs run the risk of simply choking off growth. But alternative solutions don’t offer much in the way of relief and may spark inflation.
  • Emerging Markets continue to grapple with hyper-inflation. Food and housing costs have been unbearable. Now, spiking energy prices could push these economies past the tipping point – to where growth is under heavy pressure or even reverses lower.
  • The US may be experiencing an economic recovery, but one that is feeble at best. Despite trillions of injections and liquidity programs, job growth is stale. Traders are beginning to wake up to this fact, with speculative growth names turning lower and “safety stocks” catching a bid.

It’s a turbulent environment – full of opportunity as well as risk. We’re carefully weighing our exposure to key areas (long and short) with a commitment to managing risk and protecting our capital base.

Below are a few of the opportunities we are watching closely this week:

Energy Spikes as Uncertainty Rises

With Middle East oil supplies in question, natural gas E&P companies with reserves in politically stable regions are trading at a premium. This week, we took a long position in EnCana Corp. (ECA) as the stock broke through resistance.

EnCana is active in the US and Canada and is on an aggressive growth trajectory. Last year, management publicly committed to the goal of doubling production per share over the next five years.

Late last week, the company announced a 30% investment in a Canadian liquefied natural gas export project. Once completed, EnCana will enjoy access to expanded market opportunities – adding long-term stability to revenue, especially considering the current glut of natural gas in North America. Click to enlarge:

Uncertainty surrounding fossil fuels and nuclear energy is reshaping the perception for solar energy. Up until last week, solar manufacturers were primarily traded as speculative vehicles. The assumption was that if the global economy was expanding, there would be capital available for investment in this developing technology. As traders began to embrace a “risk-off” mentality, the solar industry slumped.

But this past week, solar perceptions began to shift dramatically. The future of nuclear power is now under a cloud of uncertainty. That leaves solar as a much more viable alternative, and over the past two weeks solar stocks have broken out of their bearish channel. Click to enlarge:

Last week, we added a bullish position in a Chinese solar manufacturer and have open orders to add exposure to a second company in the group.

With PE multiples in the teens (or low-single-digits in some cases) there is plenty of room for these stocks to run. If the solar industry takes a material portion of previous nuclear power plans, it could lead to significant demand in all parts of the solar supply chain. We’re watching the area closely as price action improves.

Catching Falling Clouds

For two years now, traders have successfully bought any dips in the cloud computing group, riding momentum and strong expectations for the industry. Revenue growth has been phenomenal and adoption of the technology has spread globally.

But strong momentum has led to excessive valuations and significant risk. Two weeks ago, we noted weakening momentum patterns and identified Salesforce.com (CRM) as a potential short candidate.

Traders looking to add horizontal exposure to the group could consider VMWare Inc. (VMW). The company has a PE multiple above 40 despite the fact that growth is actually expected slow both this year and next. Now that the bullish trend has been definitively broken, momentum could pick up on the other side of the rolling top – giving bearish traders an exceptional profit opportunity. Click to enlarge:

Retail Roll?

Broad ETFs covering the retail industry have failed to gain any traction, even on days when the broad market is rallying. Late last week, markets rallied in part because of stronger than expected jobless claims. But retailers didn’t participate in the following rally and the group looks like an attractive short.

For several months now, there has been a broad chasm between retailers catering to the lower-income tier of consumers and those selling to an affluent customer base. But a shift in traders’ risk appetite now appears to be hitting even the most affluent retailers.

Lululemon Athletica (LULU) dropped 3.8% Thursday after reporting positive earnings, along with supply chain concerns. The trendy yoga apparel company bears an uncanny resemblance to a situation that developed for Crocs (CROX) a few years back.

In late 2007, CROX was on a momentum tear, trading at an excessive multiple with expectations for continued growth for years to come. But the company’s success ultimately became its downfall as supply chain challenges led to low inventory and hampered growth.

The net result was lower than expected growth, and an opening for competitors to step in and meet the consumer demand that CROX had so carefully cultivated. From a trading perspective, CROX experienced a tremendous reversal of fortune. Click to enlarge:

Will LULU’s inability to secure inventory for their expanded store base lead to a similar decline?

Only time will tell, but given the company’s premium multiple, the challenges for retailers in general, and Wall Street’s waning appetite for momentum stocks, the picture doesn’t look good. Click to enlarge:

Emerging or Receding?

The growth picture for emerging markets is now in serious jeopardy:

  • Food and housing inflation continue to take a larger portion of EM consumer income, cutting discretionary spending for all but the most elite spenders. Frustrations over higher food costs are a material issue behind social unrest in the Middle East.
  • Rising energy costs only compound the inflation problem, squeezing margins on a global scale and cutting into EM manufacturing advantages.
  • Political and fiscal decisions in the US and other developed economies have effectively exported inflation to emerging markets – and yet Ben Bernanke claims this problem is not one for the US to be concerned with.
  • A growing “risk-off” sentiment has institutional managers increasingly looking for stability. This could quickly lead to capital flows away from emerging markets and toward domestic investments with less perceived risk.

The MSCI Emerging Market Index (EEM) has been in a holding pattern for the better part of six months. But as challenges continue to mount and risk comes off the table, we could see a significant break and a major opportunity for the bears.

Incidentally, many of the country-specific ETFs offer niche opportunities to isolate particular economic issues, and also give traders a target-rich environment for picking key inflection points. More on that in the weeks and months ahead.

The broad tectonic plates of our global economy are certainly in flux.

Sometimes they shift subtly – almost unnoticed by traders and investors. At other times, the moves are violent and can trigger a tsunami of capital flowing into or out of specific asset classes.

Today’s environment fits the latter category with action beginning to heat up. We’re capturing the opportunities and managing risk as the picture rapidly evolves.

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


Source: Turbulent Market Environment Contains Opportunity as Well as Risk