U.S. markets finished last week under pressure from an unexpected headwind.
JPMorgan Chase & Co. (JPM) announced quarterly earnings which included a surprise $2 billion trading loss. The news sent the stock spiraling 10% lower and raises significant questions about the company's ability to manage risk.
On the surface, the trading loss could be brushed aside as a "one-time" mistake, that doesn't really affect the overall market. Aside from the trade, JPMorgan's "ongoing" business was relatively stable for the quarter.
But in reality, the loss is a startling reminder of how vulnerable the global financial industry has become, as a result of a number of factors:
- Europe's sovereign debt issues are creating risk scenarios that are very difficult to quantify - and even more difficult to hedge against.
- A faltering domestic economic recovery leads to uncertainty for a number of key elements affecting banks' "traditional" business lines (mortgages, lines of credit, commercial lending etc.).
- The "Bernanke put" has not only caused individuals to reach far out on the yield curve for income - it has forced the banks to accept more risk as well.
In a ZIRP (Zero Interest Rate Policy) world, investors have to become more and more creative to generate income - and that is true for corporations as well as individuals. Banks in particular have an irresistible incentive to take more trading or business risks in order to generate returns on capital they can access for nearly zero cost.
So whether Jamie Dimon categorizes the loss as a poorly executed hedge or a flat out speculative position (or even "hedging their hedge" as the WSJ reports), the bottom line is that risks are accumulating to the point where it is impossible to determine the potential outcome scenarios - which by definition increases the risks for the industry, and in turn the entire market.
Even without the JPM trading loss, equities have been weakening throughout this quarter's earnings season. Industry leaders like Apple Corp. (AAPL) are failing to hold key support lines, and more speculative growth stocks with high multiples are particularly vulnerable.
Below are a few trading areas we are watching this week.
A New Batch of Risk for Financials
JPMorgan Chase is likely to be the new poster child for the Volcker Rule aimed at curbing the amount of risk banks take through their trading desks. Under the proposed regulations, these trading desks will be relegated to hedging activities rather than speculative trading.
But the argument Jamie Dimon is making is that the botched trade in question would have actually complied with the rule as it was actually put on to manage risk.
So is that supposed to be comforting? "Don't worry that we lost $2 billion because it was actually just an incompetent attempt to manage our risk."
Institutional investors now have to take a much more serious look at the risks for the mega-banks, and are very likely to reduce their industry allocations. As capital flows out of the sector and into "safe haven" sectors, chart patterns are breaking down for financial stocks.
A breakdown in the banking sector brings back not-so-distant memories of the 2008 crisis - and fears of a repeat situation could accelerate the drop. Aggressive short sellers piling into positions just as fearful investors begin to bail could easily set off a firestorm that would quickly spread into other areas as well.
We're watching the financials closely, looking for potential entry points with reasonable reward-to-risk setups, and also viewing action in the financial sector as a good barometer for institutional risk appetite.
Emerging Markets Decelerate
As if the risks from financials and the European debt crisis wasn't enough, traders are also dealing with a major deceleration in growth from emerging markets. Economic reports out of China have been particularly soft (and there's a good chance that these numbers are still being positively "skewed" by the government).
Last week we learned that industrial production for April was up 9.3% - the slowest growth in nearly three years. India's industrial production actually fell 3.5% versus last year - a major concern for emerging market bulls.
The good news (if you want to call it that) is that decelerating growth along with lower inflation numbers give policymakers more latitude for stimulative measures.
The propensity for central banks from all sides of the globe to attempt to manufacture stable growth has had a significant effect on chart patterns - which in turn has affected traders who rely on the chart patterns to generate signals. While the macro picture still leaves traders vulnerable to choppy conditions, breakdowns in emerging market indices have the potential to create good reward-to-risk scenarios - providing the positions are managed carefully.
Cisco Drops Its Own Earnings Bomb
Aside from the JPMorgan surprise $2 billion dollar loss, traders also had to deal with a grim outlook from Cisco Systems (CSCO) CEO John Chambers.
On the third quarter earnings call (CSCO operates with a July fiscal year end), Chambers noted a dramatic slowdown in corporate spending - which he claimed was an industry-wide phenomenon, confirmed by his colleagues from competing firms.
The stock plummeted Thursday and tacked on substantial losses Friday as well - as investors bailed out of an apparently sinking ship. A few weeks ago, we noted weakness in networking stocks, and outlined a number of targets in the sector.
Now that CSCO has confirmed the weakness in the industry, the likelihood of bearish follow through is very strong. The very best scenario would be for networking stocks (along with semiconductors and possibly the hardware and software areas) to catch a relief rally or consolidation, giving us an opportunity to set up new short entries with a manageable risk envelope.
As the technology industry heads lower, trading opportunities are becoming more attractive, and we are willing to commit more capital to bearish bets.
Equities are opening soft to start the week with more Greek drama and plenty of risk in play. We're comfortable with our bearish exposure, and tightening our risk points to lock in profits.
This week we have a number of key retailers announcing earnings (Target (TGT), Wal-Mart (WMT), Abercrombie & Fitch (ANF), Limited (LTD), Gap (GPS), etc.) along with plenty of news from Europe, the financials - and of course the Facebook IPO.
Stay nimble and alert. There are plenty of crosscurrents even as some of the haze is removed from the bearish big picture.
Trade 'em well this week!
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/