Economy Heading Into No Man's Land?

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 |  Includes: ACIIQ, GAZ, ITB, TZOO, WLT
by: Mercenary Trader

By Mike McDermott

Last week began on an extremely bearish note. As Standard & Poors downgraded the outlook for US debt, retail and institutional investors panicked and prices dropped. Initially, it looked like this could be the catalyst for the market to finally begin recognizing the mounting risks.

But true to recent form, the bulls wouldn’t go down without a fight. Even though it was a shortened holiday weekend, equities covered plenty of ground. The major indices finished positive on the week, pushed up against (and in some cases through) recovery highs.

The action leaves us as traders squarely in no man's land. That is to say, it is increasingly difficult to find attractive trading opportunities that offer a positive risk / reward scenario.

For bullish trades, the momentum is certainly favorable. Bulls have shown both their ability and willingness to buy the dips, buy the new highs, and buy just about everything in between. But many overall chart patterns are now extended (both from a short-term and a long-term perspective) and the economic risks continue to mount.

For bearish trades, the environment is clearly hostile. Despite the fundamental arguments for lower price multiples, slowing growth, and macro risks, stocks still continue to push higher. We’ve taken some pot-shots shorting this market, with mixed results. Some trades have generated profits as sectors have fallen out of favor, but other short candidates have continued to be lifted by a flood of liquidity in the system.

Heading into this week, our exposure is significantly trimmed, with only a few small positions on either side of the ledger. While we continue to scour the markets looking for profitable shifts in the environment, we are very cognizant of risk. The following is an excerpt from the Mercenary Live Feed Weekend Review:

It is not out of character for markets to reside in a place where bullish charts contrast with an extremely dangerous fundamental backdrop. This is the “fat tail” or “outlier” portion of the greed cycle, during which self-reinforcing perceptions of invincibility cause increasingly ominous warning signs to be ignored, up to the point of violent resolution.

So as we step into another eventful week of trading, here are a few of the setups and scenarios we are tracking:

Coal Rides the Energy Trend

As oil prices continue to climb, a bullish backdrop has been influencing prices for other energy sources. The nuclear disaster in Japan also helps to boost demand and spot prices across the energy spectrum.

Coal prices are influenced not only by energy demand, but also because it is a key input for steel. As investors continue to buy into the emerging market expansion story, expectations for coal demand continue to rise.

Arch Coal (ACI) has been in a bullish long-term pattern after hitting a low in late 2008. But since December, the stock has been stuck in a tight range. Aggressive traders could begin building positions at the low end of this range with a tight stop if the stock actually breaks through support.

A more conservative approach might be to buy a breakout to new highs. But buying the breakout could be a bit more dangerous considering this market’s tendency to punish breakout / breakdown traders.

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Walter Energy Inc. (NYSE:WLT) is another strong name in the group. On Thursday, the company announced earnings significantly higher than the first quarter last year. While the actual Q1 profits were a bit below expectations, investors bid the stock higher by Thursday’s close.

The key issue in WLT’s earnings report was the average selling price for a ton of coal. Average selling price was up 52%, mimicking similar metrics reported by Patriot Coal (PCX). Considering the strong demand and positive trends for energy stocks, WLT could be an attractive trading opportunity as long as risk is carefully managed.


Natural Gas Producers: New Catalyst?

Natural gas producers have developed relatively healthy patterns. This has surprised a number of traditional analysts because of the bearish patterns for natural gas as a commodity.

It’s true that natural gas prices have declined significantly over the past three years. But at the same time, the level of production has increased tremendously, and producers have been able to book much larger reserves (noted as assets on the balance sheet) because of fracking technology.

Natural gas trapped in shale formations are now accessible, and the US has been dealing with an increasing glut of gas. Producers have had to deal with a lower selling price, but that has been offset by increasing reserves and strong demand.

Today, a new dynamic may be on the horizon. It’s too early to make a definitive call, but natural gas prices may have found a floor. If demand is picking up to a point where it is matching our heavy supply, producers could enjoy the tailwind of increasing prices.

Well-known natural gas producers like Chesapeake Energy (NYSE:CHK) have already staged bullish runs, even with a declining spot price for natural gas.

If natural gas stabilizes or begins to rally, one would expect producers to generate even stronger advances. Profitability would increase as gas is sold at a higher price, and the residual value of reserves would increase as well. In this environment there are a number of major producers as well as niche E&P companies that could experience significant gains.

Bearish Plays Still Too Risky

Today’s market features a number of extended stocks that make for very tempting short opportunities. But the reality is, for the most part, extended stocks are simply becoming more extended. Bearish traders are either getting stopped out, or watching losses accumulate.

Travelzoo Inc. (NASDAQ:TZOO) is a good example of this. The stock features a high level of short interest (bearish bets) and trades at about 63 times expected earnings for this year. The company operates in a very competitive field dominated by Expedia (NASDAQ:EXPE), Priceline.com (NASDAQ:PCLN) and a few other dominant players.

Despite the valuations and challenges, “true believer” shareholders continue to be rewarded for holding on to their positions. On Thursday, the stock reacted to another earnings beat, hitting yet another new high. The stock is now up more than 700% from its July low.

This kind of scenario usually ends in tears for investors, but all too often the bears cry along the way as well. We continue to build a list of extended and vulnerable short candidates, but we are hesitant to put any capital to work until the broader market shows significant signs of stumbling.

Homebuilders Lagging

Despite the strong action in the broad market, homebuilders had a bit of a disappointing week. We have identified ITB as the better alternative for a home construction ETF. The other ETF in play is XHB, but that security is comprised more of home-related retail chains.

ITB clearly broke out of a consolidation on 4/20, only to fall back into the pattern the following trading day. This formation could leave breakout buyers trapped in a losing position – and could add to selling pressure.

Heading into the new week, our biggest question is how far the bulls can push this action. It could be that we’re in the final stretch with a major dislocation approaching. Or it could be that we continue to experience higher prices through the summer.

Price action will continue to be our primary timing mechanism, with plenty of fundamental research helping us identify the best candidates on both sides of the ledger.

Keep that risk tightly managed as we wait for the best opportunities to strike.

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