By Mike McDermott
March came in like a lion, with the indices experiencing their first significant correction since Q2, 2010.
But by the end of the month, equities had recovered nicely, with the S&P 500 and DJIA finishing the month within striking distance of a new recovery high. In fact, on Friday, the Dow actually crossed into territory not seen since the first half of 2008 – a testament to the strength of increasingly bullish investors and traders.
While some groups have now become a bit extended, the general consensus seems to favor another “risk-on” period for equities. As I mentioned last week, all of the major indices are now above the line, in terms of the 50-day EMA.
Our trading book reflects the price action as we have picked up exposure on the long side – with a particular focus on energy opportunities, and emerging market strength.
To protect against yet another reversal, we continue to tighten risk points along the way. The Mercenary Live Feed has also set up a number of pending short positions that will only trigger entries if the price action turns negative. For now, we’re happy to continue to ride our bullish exposure as equities levitate. But if the tide turns once again, we’ll be ready with our bearish entries triggering and our exposure well-balanced.
So as we roll into the second quarter, let’s take a look at the areas we are focused on this week.
Shippers Emerging From Long Base
In bullish markets, traders typically have the choice of chasing extended moves, or entering new areas that are following the trend and breaking out of bases. There are risks to both approaches.
Extended groups are typically more prone to reversals. They have already generated significant profits for traders who were early to the party. With even a whiff of trouble, traders sitting on large gains can bail out and take profits – crushing the chasers who may have bought recently, only to get shaken out.
Groups that break out later in the bull cycle should be scrutinized carefully. It’s important to understand why their breakout was delayed and the prospects for how far the group could rally.
The shipping sector is beginning to move higher after lying dormant for an extended period. On Wednesday, we issued our Strategic Intelligence Report on the group – noting that day rates appear to have found a floor, and many individual shipping companies are trading at very attractive prices.
Institutional investors are clearly buying into the emerging market growth theme, as can be seen in the bullish price action for ETFs like EEM, INP, EWZ, EFA among others. If emerging markets are attracting capital, it’s only natural that the shipping area will begin to see more activity – and more investment capital.
On Friday, the Mercenary Live Feed took a long position in one member of the shipping group as the stock traded out of a well-formed base and hit a new three-month high. With a PE near 6, and earnings growth on the horizon, our potential profit should be many multiples of the initial capital at risk.
Trades with strong potential “R” or reward to risk ratio, are the reason why a high winning percentage only tells a small part of the story. Setting up trades with potential for “home run” returns is much more important than focusing on a contrived win/loss ratio.
Diana Shipping Inc. (NYSE:DSX) is another shipper with the potential for a return that is many multiples of our capital at risk. The stock has been forming a multi-month wedge pattern, and is trading at roughly 8.5 times expected earnings for this year.
As rates begin to improve, and emerging markets drive demand for shipping capacity, DSX should see expectations increase and profitability improve. A dynamic process of higher earnings and stronger price multiples could easily propel DSX from $12 into the mid $20′s or higher. The key for us as traders is to wait for the proper timing, and then be ready to pounce once the price action confirms.
Rising Fortunes for Solar Energy
The solar energy sector is another area that is rebounding out of a long-term basing period. The attraction when it comes to this group comes from both value and growth. With energy prices rising and most solar companies trading at attractive multiples, the ultimate profit potential for the are is impressive.
Solar energy already experienced a speculative bull market about five years ago. During this time, the concept of solar energy was much more theoretical than practical. The actual costs to produce electricity from solar energy were far higher than typical grid costs from traditional fuels like coal or natural gas.
Stocks rallied based on the expectation that eventually solar power would become more efficient. And for the short-term, governments around the world were subsidizing the industry, making profitable companies even when the technology was NOT profitable.
After several years of wringing the excess out of the system, the solar industry is once again ready to rally. Only this time, the fundamentals and the macro picture look much more robust.
Uncertainty in the Middle East, and growing demand from emerging markets is driving up the price of traditional oil. Natural gas prices have remained low, but that’s primarily due to a supply glut from new drilling and production technologies. The demand for natural gas continues to rise, with a virtual land grab underway as countries secure supplies for years to come.
The primary risk for today’s solar producers comes from government subsidies. Cash-strapped European countries are cutting back on renewable energy projects, which means the solar industry is increasingly being forced to operate on a level playing field. So solar stocks have been locked in a tug-of-war between bulls who see dramatic shifts in demand for renewable energy, and bears who see a more difficult competitive environment.
In late 2008, Suntech Power (NYSE:STP) looked like it was on its way to bankruptcy court. Excessive debt, falling oil prices and industry competition made for a very difficult competitive environment.
But today – more than two years later – the company has made significant changes. Debt levels have been cut back to reasonable levels, the company is generating a respectable profit, and the stock is once again beginning to look interesting. Improving profit expectations, and a better perceptions of the industry could drive prices sharply higher. If STP breaks out of this long-term base, it could easily double or triple by the end of this year.
We have three different solar stocks in the Mercenary Portfolio heading into this week. Exposure to the solar industry is another way to participate in bullish emerging market sentiments, without paying premium prices for EM growth stocks.
As institutional managers become more selective about what emerging market themes they will allocate capital to, we expect the shipping and solar areas to benefit.
Airlines Offer an Effective Hedge
With significant exposure to rising energy prices, we’re carefully weighing the risk of a pullback in this area.
We’re entering this week with a few pending orders to buy airlines should the price action trigger our entries. The airline trade offers us the ability to counterbalance our existing exposure, and the stocks appear to have priced in higher oil prices and a challenging environment.
A pullback in oil prices would give institutions a good reason to step into airlines such as Southwest Airlines (NYSE:LUV) – a low-cost domestic carrier with improving profits and strong revenue trends.
The airline trade (which includes potential exposure to a number of different carriers) may not ever trigger an entry. If oil prices remain high, it wouldn’t be surprising to see these buy orders eventually cancelled.
But the concept is another example of how we position our trading book to take advantage of different scenarios – with a focus on making money, rather than an obsession with “being right.”
Chip Makers Heading South
One final area of counterbalance is the semiconductor group.
The group has attracted plenty of capital over the last several months, but now appears ready to roll south. We’ve seen major trend lines broken for the broad group, and individual chip makers are developing bearish chart patterns.
We’ve got our finger on the pulse of a few individual stocks that we like from the bearish side. But as seen in the ETF chart below, the entire group looks weak, and should offer a number of attractive setups if the broad market rally runs into resistance.
We’re heading into our first full week of the second quarter – with just a short amount of time before earnings reports begin pouring in again. Futures are indicating a moderately positive open, and we’re situated to book strong profits from this type of environment.
Disclosure: As active traders, authors may have positions long or short in any securities mentioned. Full disclaimer can be found here: http://mercenarytrader.com/legal/