Equities were dealt a crushing blow on Friday with the major indices all giving up between two and three full percentage points.
All of the bearish wedge patterns featured in last week's turret were definitively broken and the bears were controlling the action with impunity.
Friday's action was especially bloody because there were multiple catalysts behind the action:
- European debt crisis expansion with rates on "safe" German bonds falling below zero (Bloomberg)
- Chinese manufacturing slowdown indicates poor global economic growth (Reuters)
- US Employment disappoints with less than half the expected jobs added in May (WSJ)
Stepping back and looking at the market from a long-term perspective, the situation looks ominous. US equities have spent a bit more than three years repairing the damage from the 2007-2008 financial crisis, and now look to be tracing out a broad topping pattern.
From this perspective, there is plenty of room for additional weakness, with the "good" scenario allowing for support to hold between 1100 and 1000 - and the "bad" scenario featuring a full-fledged breakdown back to the '09 lows.
The macro picture is bad enough (impossible European debt crisis, stalling Chinese growth, and more US pain) to justify forecasts for a cathartic breakdown, and there are a number of well respected macro traders calling for just such a situation.
But from a shorter-term perspective, Friday's action was bearish enough to leave the daily charts oversold. It didn't take long for sentiment to turn broadly bearish, and now a short-term rally may be the path of maximum frustration that catches bearish traders off-guard and invites "bottom pickers" to take a stab at new long positions.
With short-term patterns in this oversold condition, we are unlikely to initiate new positions early in the week. New bearish positions would be vulnerable to a dead-cat bounce, and there simply aren't too many traditional long positions that we could embrace at this point.
However, we still have a strong stable of profitable shorts to manage as we balance the benefit of tightening risk points to protect our gains, and still giving these positions elbow room to evolve into much more profitable trend trades.
Below are some of the industries, groups and themes we are closely monitoring this week…
Retail Weakness Accelerates
Last week we talked about the slowdown in luxury spending across the globe. Specifically, Tiffany & Co. (NYSE:TIF) announced disappointing sales from Europe to China to the US.
This week, the luxury retail sector continued to take it on the chin as institutional investors reduced exposure to speculative issues, breaking chart patterns on their way out the door.
Based on the choppy action we have seen over the past two years, we're happy to book quick profits when they are available, and covering half of the position while tightening our risk point to break even on the second half still allows us to play for a much larger move.
A consolidation or short-term rebound in the group would allow us to build some horizontal exposure in the retail area - possibly taking shots at relatively new and evolving breakdowns like Lululemon Athletica (NASDAQ:LULU), Gap Inc. (NYSE:GPS), or Zumiez Inc. (NASDAQ:ZUMZ).
As the economic picture darkens, the negative feedback loop will be especially tough on the retail sector. Consumers have begun to run out of credit options and the employment picture is souring. A slowdown in the sector will lead to layoffs, more employment challenges, and less incentive to spend. The bearish retail theme could end up being in play for quite some time.
Homebuilders: Back to Shortable Levels
For the last year, we've been a bit skeptical of the broad rally in homebuilder stocks. Deferring to the bullish price action, we haven't taken any bearish bets. But considering the fundamental risk for the industry, we haven't felt comfortable putting our capital on the line from a bullish perspective.
This week, a number of key home construction stocks broke their bullish trendlines. Thanks to the strong sentiment this group has enjoyed for the last 18 months, homebuilders are now breaking down from premium price multiples - giving them plenty of room to drop before valuations become enticingly cheap.
Headline statistics have been misleading with declines in the number of bank foreclosures giving investors false hope. According to housing expert Keith Jurow, banks are avoiding foreclosures in an attempt to avoid pressuring the market even further (Business Insider).
Of course, with any rebound in housing activity, banks will restart the foreclosure process and attempt to recoup the capital they have lost in mortgage transactions.
Now that the price action has turned bearish for this industry, (and the broad market is providing a tailwind), we're watching for opportunities to short rallies or consolidation patterns and participate in continuation declines as investors lose faith in this faltering group.
Precious Metals Reverse on Icy Data
While the majority of sectors were getting pummeled by the bearish action on Friday, one particular area exhibited uncharacteristic strength. The precious metals universe basically turned on a dime and rallied sharply - breaking through resistance areas and attracting significant amounts of capital.
Friday's action was a game changer for precious metals as investors transitioned from lukewarm growth expectations to an icy environment where slowing growth leads to more action from central bankers - and ultimately currency debasement.
Ironically, the weak economic picture provides multiple catalysts to propel gold miners higher. Poor growth expectations has led to a massive drop in oil prices, which in turn lowers production costs for the miners. The same could be said for labor costs which should also ease in a negative growth period.
At the same time, liquidity injections and the fear of currency weakness directly affect gold prices, allowing miners to sell their production at inflated prices.
Now that the initial surge has taken place, we're watching for pullbacks and researching individual miners to determine where the best opportunities are. Over the next few months, we could build a stable of longer-term gold miner positions with potential for massive profits as sentiment levels shift dramatically.
As Asian markets open and overnight futures begin to trade in the US, the weakness looks set to continue. S&P contracts are down 7 handles early in the session and Angela Merkel continues to drive a hard line against German-backed debt solutions.
Our bearish positioning should continue to generate profits, even as we manage positions and lock in profits along the way. However, volatility is likely to pick up this week as solutions must be found in order to prevent even more crisis-like action.
Capital preservation still remains the key to success, even as profits begin to accelerate. We're still in a very uncertain environment and putting too much capital at risk (on the bull OR the bear side) is especially dangerous at this time.
Trade 'em well this week!
Disclosure: I am short COH.