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By Mike McDermott

Equities held up well in the first trading week of the year. This is particularly noteworthy, considering the euro broke down to a new low with sentiment for Europe’s debt situation remaining very low. On Friday, we were able to take half profits on our euro short – even while US equities were holding up near recent highs.

The question at this point is whether the strength in US markets was an indication of underlying strength (not falling even though headlines from across the pond continued to be negative), or if it was simply a seasonal issue with money managers putting new capital to work regardless of the overall economic environment.

This week we should get more clarity as earnings season officially kicks off with Alcoa Inc. (NYSE:AA) reporting after the close today. The company already pre-announced restructuring charges last week, and the expectation is for a drastic reduction in earnings as a direct result. But traders will be listening carefully to the conference call to determine if management can confirm early signals that the global manufacturing environment is rebounding.

Friday’s jobs report offered a few additional optimistic data points, with the unemployment rate ticking down slightly and private payrolls adding more jobs than expected. With economic reports now coming in above expectations, it wouldn’t be surprising to see US stocks break above resistance levels and run for a few weeks.

Even though overhead risks are still in place, investors have been aware of these issues for some time, and are now dealing with headline fatigue. A few weeks in rally mode could set up some excellent short opportunities (remember, the risks are still in play), but in the meantime we are approaching our trading from a more balanced perspective – looking for good reward-to-risk opportunities to add bullish exposure.

Below are a few of the areas we’re tracking for the week ahead…

Fertilizers Find Support

Last week’s action in Monsanto Co. (NYSE:MON) caught our attention as the seed and agriculture product manufacturer announced strong fiscal first-quarter earnings. The company noted particular strength in Latin America and the United States, and boosted its outlook for the entire year.

Buying Monsanto after a sharp breakout (into resistance no-less) isn’t a very good trade when you consider the risks. The stock could easily slide back and stop us out without damaging its technical pattern. But a number of fertilizer stocks look much more attractive.

As a group, fertilizer stocks have declined as expectations for the global economic recovery have become jaded. A grain glut complete with weakening prices has led to disappointment when it comes to expected demand for fertilizer products.

But over the last quarter, fertilizer stocks appear to have found support and are trading at much cheaper valuations than we saw early in 2011. Potash Corp. (NYSE:POT) is now back to a price point below the 2010 consolidation after an unsuccessful takeover bid by BHP Billiton (NYSE:BHP).

Agriculture prices are notoriously cyclical – and of course fertilizer pricing and overall demand falls alongside crop pricing and production. Sentiment for fertilizer manufacturers is negative with plenty of room for improvement. A break above key technical levels such as last week’s swing high – or the 50 EMA – could be a catalyst for traders to pile in.

(Click charts to expand)


Steelmakers Ride Manufacturing Optimism

Encouraging manufacturing data has traders eyeing a number of potential sectors for rebound potential. Steelmakers in particular look attractive as capacity levels have been cut significantly over the last decade, and the remaining manufacturers now operate leaner businesses with potential for stronger margins if pricing improves.

Nathan O. has identified a particular steelmaker as the “chart of the week” in his Global Trend Capture service (currently in a beta testing period). This morning, we reported a new pending long for a steelmaker as well.

At this point, we’re not holding any position in the sector, but recent action has set up some compelling entry points should the action continue to improve.

Take a look at the Market Vectors Steel (NYSEARCA:SLX) ETF below. The sector has rallied sharply off the October low, and consolidated into a narrowing wedge pattern. Last week, SLX gapped higher to begin the year and a move above this 4-day consolidation would be a positive sign. Individual steelmakers have similar patterns, and may offer more compelling trades depending on the individual company dynamics.

Semiconductors Becoming More Constructive

As consumer confidence picks up and employment numbers tick higher, demand for semiconductors is strengthening. Industry leader Intel Corp. (NASDAQ:INTC)
is trading near a 3-year high, and the entire industry is experiencing positive price action.

From a technical perspective the Market Vectors Semiconductor ETF (NYSEARCA:SMH) is at an interesting juncture. The security broke out of a wedge pattern and is above the key 50 EMA. Last summer, the ETF repeatedly tested support just below $26 and that price point has become a rock-solid floor.

A rally this week would trigger a pending long for us – with a relatively tight risk point in case the breakout does not follow through. Given our modest bearish exposure at this point, we’re willing to be a little more aggressive on bullish trades, as our overall risk is muted by our profitable short positions.

Option Spotlight

This weekend, I ran a screen for covered calls expiring in February. As you can see below, the parameters were:

  • Stock Price below $150
  • Probability of expiring in the money above 75%
  • Expiration in 45 days or less (February expiration)
  • Return on investment 2.0% (not annualized)
  • Downside protection above 10%

There were more than 30 different setups that matched my criteria (with some stocks featuring more than one option strike that met the parameters). The Direxion Energy Bull 3X caught my attention as the ETF has been consolidating above the 50 EMA after a false breakdown in October.

The covered call setup offers nearly 30% downside protection – reducing the risk in this trade significantly. A covered call using the February 39 strike price yields a return of 2.28% – or about 20% annualized and creates an attractive opportunity for idle cash sitting on the sidelines.

This week has the potential to be a major indicator for the remainder of the first quarter. Watch traders’ reaction to earnings news as it comes out for clues as to how sentiment is positioned and which direction it is shifting too. Don’t let “expectation bias” affect your trading decisions as price action is a much better indicator than any economic or model-based assumptions.

Source: Strength Or Seasonal Effect?