By Mike McDermott
Starting this week, investors will once again begin reacting to another round of earnings reports. Up until last week, expectations had been for healthy earnings growth with optimistic forecasts from management. A robust three-week rally squeezed the shorts, emboldened the bulls, and shifted sentiment back to positive territory.
But Friday’s non-farm payroll report changed everything…
Economists had been expecting a reading of 80,000 jobs added in June. Not only did the actual reading come in at a disappointing 18k level, but the May figures were also revised lower by more than 50%. Equity markets responded by performing another “about-face” (which seems to be the trend this year), and the newly bearish chart formations for the major indices now have traders once again pondering the importance of risk management.
As we enter the second quarter earnings season, the burden of proof should now rest on the bull camp. Will managers succeed in convincing investors and analysts that the coast is clear? Or will bullish expectations yield to disappointment and lower security prices?
There are no guarantees in this environment, but the risks once again appear to give the bears an edge.
Below are a few of the setups that we are tracking as we enter earnings season…
Base Metals and the Alcoa Release
After the close Monday, Alcoa Inc. (NYSE:AA) will kill kick off earnings season with its Q2 release. Analysts are expecting the aluminum miner to report earnings of $0.34 (a 161% increase over the second quarter last year). Strong demand from emerging market infrastructure projects has helped to bolster earnings for the entire base metal complex.
More important than the actual earnings report will be the company’s forward guidance. Investors will be listening for any hint of weakening end markets, while at the same time keeping an eye out for cost inflation. Higher commodity prices can be both a benefit and a detriment to these mining companies.
The good side of commodity inflation is that base metal miners end up with a higher end price for their production. But of course the cost inflation for fuel, equipment and labor can crimp margins. With inflation expectations experiencing plenty of volatility, it will be important for companies to hedge both the selling price for production as well as the variable costs.
Looking at spot prices for the base metals, the action is a bit dangerous. Last week, the complex broke above resistance and appeared set to challenge recent highs. Friday’s bearish action now calls the breakout into question, and with more weakness today, the breakout could turn out to be a headfake.
If spot prices fall Monday, it could make the earnings call more difficult for Alcoa management this afternoon.
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Emerging Market Weakness
At first blush, the disappointing payroll report may appear to be a domestic issue. After all, 70% of U.S. GDP is driven by consumer spending – and unemployed consumers are usually poor spenders…
But weak employment in the U.S. and harsh austerity programs in Europe are a major drag on emerging markets as well. China in particular depends heavily on exports for economic growth. With developed markets facing renewed economic challenges, those exports are being called into question and investors are rethinking the growth multiples placed on emerging market equities.
The iShares China 25 (NYSEARCA:FXI) looks particularly vulnerable, both because of the fundamental risk to exports, as well as the evolving technical pattern. After breaking support from earlier this year, the ETF rallied directly into a confluence of moving average resistance.
For our part, we took a short position in FXI late last week as the rally stalled. With risk points above the recent highs, we’re giving this new position some room to wiggle, but it appears the timing will prove correct as sentiment is clearly shifting for emerging markets.
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Social Media – Competition for Capital
Social media companies continued to grab headlines last week after Living Social filed the initial paperwork for an IPO transaction.
Josh Brown at The Reformed Broker broke down why this company’s business model will likely prevail over Groupon – and then why Google (NASDAQ:GOOG) will eventually overtake both enterprises. You can check out his take on Living Social and Groupon is here.
We’ve already talked about the risks in some of the recent social media IPOs, and as the market begins to turn south once again, these companies are looking vulnerable.
LinkedIn (NYSE:LNKD) has worked its way back to the $100 level which may turn out to be a key inflection point for traders. The chart looks relatively bullish, but the valuation implies that investors are looking for tremendous growth. We’re sitting on our hands for now, but a breakdown could offer a tremendous short opportunity.
Pandora Media Inc. (NYSE:P) looks a bit more interesting, within shooting distance of its $16 IPO level. Now that some of the hype has had time to wear off, investors will be thinking more carefully about the company’s business prospects. At the same time, the lockup period will be expiring shortly and investors may want to take some profits before these shares are able to hit the market.
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Fertilizer Stocks Offer Bullish Perspective
Agriculture commodities have experienced tremendous volatility over the last couple of weeks. Farmers had a record planting season which caused supply expectations to spike (leading to lower prices).
But an interesting article in Sunday’s Links Roundup noted that China is aggressively buying U.S. corn – which is likely to help support prices and soak up supply.
All of this makes for an interesting environment for fertilizer stocks. As farmers put more seed in the ground, and demand continues to keep pace with supply, the need for fertilizer only increases.
We’ve been watching the area closely and have two starter positions in play, with a third setup waiting for price confirmation. If the trend continues, we will likely add exposure to these initial trades, expecting to ride a significant trend higher.
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With earnings season bringing plenty of additional data to the table, and the market experiencing yet another sentiment shift, this could be a very interesting week.
Disclosure: As active traders, authors may have positions long or short in any securities mentioned. Full disclaimer can be found here.