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by Mike McDermott

Last week’s market action was a victory for the bulls, in the ongoing “risk-on / risk-off” struggle that has become a hallmark of 2011.

The major indices are trading back up towards previous highs and so-far, the second quarter earnings season has left investors in an optimistic mood. This week traders will be watching overhead resistance levels carefully – with a breakout offering plenty of ammunition to pile into leveraged exposure.

Of course a stall from these levels would indicate more choppy waters ahead as the directionless action continues.

From a macro perspective, markets have been quick to rejoice over a European resolution that should give Greece funding through 2014. Investors are also hopeful that US lawmakers will be able to pull off an 11th hour save and reach an agreement between Democrats and Republicans to lift the debt ceiling. Whether well-founded or naïve, the positive outlook has been enough to encourage increased capital allocations into global equities

On the micro, or stock-specific front, the reaction to earnings season has been somewhat of a mixed bag. Just take last week’s split between big-ticket retail companies like Harley Davidson (HOG) and Polaris Industries (PII), and the reaction to industrial giant Caterpillar (CAT) earnings report.

Investors still appear more than willing to accept strong growth from the high-end consumer market, while fears of rising costs and slowing emerging market demand continue to hold down large industrial companies.

The Mercenary trading book has been adding more long exposure over the past week, but still holds a relatively balanced allocation when it comes to bullish and bearish concepts. Our short “bender trade” is still in place, offering us an opportunity to capitalize on any sharp dislocation for US equities, while individual equities have been added to participate in a “grind-higher” environment.

Here are a few areas that we’re tracking as we head into another week of earnings data:

Fert Stocks Resume Bullish Trend

After taking a break in the first half of 2011, fertilizer stocks are once again moving higher. Fundamentally, the group is benefiting from a number of different catalysts:

  • In June, a consortium of fertilizer producers negotiated a price increase for potash being shipped to China. The new standard price is $470 per ton – above the $450 analysts were expecting.
  • Rising emerging market demand for ag commodities continues to encourage farmers to use more nutrients – improving crop yields and leading to strong farming profits.
  • Difficult weather in key wheat producing areas has cut supplies and acted as further incentive for farmers to increase crop yields.
  • Last week, a USDA report showed a decline in the quality of crops – which should increase demand and pricing power for fertilizer producers.

Mosaic Co. (MOS) reported a 66% increase in earnings, and a 54% increase in revenue for the second quarter. The report sent the entire fertilizer group higher, benefiting the three related positions we currently hold in the Mercenary Live Feed portfolio.

MOS has now broken solidly above its key moving average lines, and has cleared short-term supply levels. We’re managing our positions in the group carefully, with an eye for adding exposure at key inflection points along the way. Click to enlarge:

Financials Attract New Allocations

Financial stocks (particularly the mega-banks) have become some of the most hated companies on the street. Consumers and taxpayers feel betrayed. Politicians capitalize on this sentiment and know to avoid any alignment with banking institutions. On Wall Street, fears of European debt contagion and mortgage exposure has led to depressed multiples and bearish price patterns.

But from a trading perspective, some of the best opportunities come from broad, tectonic shifts in sentiment. For the financials, this shift may be coming as Europe appears to have successfully engineered a debt stop-gap, while no financial time bombs have exploded in the last several quarters.

So despite the negative sentiment, last week we began building some starter positions in US banks. If this trade is successful and sentiment really is undergoing a transition period, bank stocks could have a long way to run – just to make it back to “normal” valuations.

On the other hand, if recent action is just a “head fake” our relatively tight risk points will keep us from experiencing too much of a loss. This asymmetrical risk/reward profile is an important part of generating a strong long-term equity curve, while always managing our drawdowns carefully.

Incidentally, Barron’s had an interesting article over the weekend noting that David Kotok, Chief Investment Officer at Cumberland Advisors is plowing over 20% of his capital into financials, expecting a rebound following the Greek restructuring. Kotok classifies himself as a “terrified optimist,” noting that there is risk in the area, but plenty of potential for strong profits.

Energy Reacts to $100 Oil

As bullish traders retook the leadership last week, oil prices attempted to retake the $100 level. WTI crude finished the week at $99.73, but that’s “close enough for government work” and represents a new 30-day high.

Higher crude prices have a trickle-down affect for a number of related industries. On Friday, oil service major Schlumberger Ltd (SLB) announced earnings and noted strong demand from E&P (exploration & production) customers.

The stock could have plenty of room to run considering its valuation and growth profile. SLB is currently trading at 25 times this year’s expected earnings, but analysts are calling for an additional 38% increase in EPS next year as robust demand continues.

It’s a bit difficult to justify a buy at this point – the stock has rallied right into a long-term resistance level – but SLB could be an attractive purchase on a pullback, especially after resistance levels have been penetrated. Click to enlarge:

China Gaming – Social Expansion

Bullish investors have once again started building positions in the China Gaming area – betting on continued growth for a number of industry leaders.

The top companies in this industry continue to log quarterly revenue and earnings growth as the number of gamers grows. The online portion of the Chinese population has been growing as individuals transition from an agrarian lifestyle to more urban locations.

The good news for online gaming companies is that there is still a large untapped portion of the market, and future growth should continue to be robust.

Netease.com (NTES) has had impressive revenue and EPS growth over the last three quarters and is developing a bullish trading pattern ahead of its August Q3 announcement. Additional names in the area – Sohu.com (SOHU) and Changyou.com (CYOU) also have bullish patterns and the group could be an interesting “risk-on” play for bullish market environments. Click to enlarge:

It’s going to be an interesting week with plenty of economic and earnings data to drive volatility. Stay nimble, protect that capital, and trade ‘em well this week!

Disclosure and Disclaimer: This content is general information only, not to be taken as investment advice or invitation to buy or sell securities. As active traders, we may or may not have positions in securities mentioned. For full disclaimer click here

Source: Back to the Highs