Welcome to the third quarter of a genuinely nutty trading year…
The second quarter went out with a bang as the S&P 500 tacked on 2.5% in Friday's session, and the Nasdaq Composite rallied a full three percentage points.
Given the poor economic picture and the bearish sentiment on the street, it's easy to see how this was the perfect opportunity to roll out a massive short squeeze.
Leading up to the end of the quarter, bearish traders were gaining confidence, as a trifecta of major macro issues converged:
- In Europe, the debt crisis appeared to be approaching a climactic showdown.
- Traders are reacting to growing expectations for a hard landing in China.
- In the U.S., the economic picture is tilting toward a grinding recessionary environment.
With a significant amount of pessimistic sentiment, and the technical picture looking very negative, traders were gravitating to the bearish side of the ledger. German rhetoric was becoming more hard-nosed against shouldering the debt burden - leading to a major showdown for Europe.
So when Merkel flipped scripts and offered concessions, traders were caught off guard and leaning too far in the wrong direction.
It didn't help matters that this was the last day of the quarter - a prime window dressing session. Seizing the opportunity, institutional long-only investors were able to add pressure, forcing more shorts to cover and driving up prices to be marked-to-market for the quarterly reports.
So as we head into the second half of the year, we find ourselves at a very interesting juncture.
Short-term, the buying pressure is strong and it would not be abnormal for a major short squeeze to last for several trading sessions. With a holiday-shortened week in the U.S., lower liquidity could exacerbate the action and allow for a larger price movement.
But fundamentally, there still isn't much to get excited about. Europe STILL has a major debt crisis and there is no easy solution. Even Germany's concessions are not going to be enough to turn the tide. China is still a great candidate for a hard landing, and the U.S. is still on course to re-enter a recessionary environment.
We're keeping most of our powder dry, but licking our chops at some of the short opportunities that are setting up. If the rally fizzles and fear comes back into the market again, the reset caused by Friday's massive push higher could give us some great entry prices - along with plenty of room for bearish trends to run.
Below are a few of the bullish and bearish areas we are focusing on for the first week in this new quarter…
Energy Extended - More Short-Term Opportunities
As the global economic picture has worsened, energy has been one of the areas that has been hit the hardest.
Oil prices have spent the entire second quarter under pressure, with the iPath Goldman Sachs Crude ETN (OIL) remaining below its 20 EMA since the beginning of May. That's a long time for a major commodity to remain under consistent, almost daily selling pressure.
But as we neared the end of the quarter, crude found buyers at a major support level dating back to the second half of 2010. Given the bearish sentiment and the short-term extended price action, the energy complex offered a great reward-to-risk opportunity (from the long side).
Last week we ended up taking short-term bullish trades on both Penn Virginia (PVA) and Swift Energy (SFY). The snap-back action allowed us to capture quick profits as documented in real-time via the Mercenary Live Feed.
With natural gas improving significantly over the second quarter, and crude oil bouncing off long-term support, we could continue to see strong bullish opportunities in energy producers as well as transmission, storage and refining stocks.
Financials For a Bounce…
The financial sector represents another short-term bullish area that we are active in.
As traders react to the prospects of a temporary European resolution (key word being temporary), sentiment levels for banks could be in for a dramatic shift.
PE ratios for regional and national banks are at levels that reflect a significant amount of uncertainty for the industry. But meanwhile, bank profits have continued to hold up well, and most bank stocks are paying attractive dividends.
There is still too much balance sheet (and off-balance sheet) risk for these stocks to once again be considered "widow & orphan" safety investments. But a decent yield and relative value, along with a shift in the Europe perspective, should be enough to keep bank stocks in an uptrend at least for the next few weeks.
On Friday, we took a long position in both Wells Fargo (WFC) as well as U.S. Bancorp (USB). Both positions were set up and communicated to Live Feed subscribers before the open. Both WFC and USB gapped through our stop / limit buy orders but pulled back during the session to hit our limit prices before trading higher to close out the quarter.
As long as the major banks avoid an ugly earnings season, and barring any immediate reversal of fortune in Europe, banking stocks should continue to melt higher. We're not expecting a major long-term trend to hold up, but given the attractive yield and sentiment shift, we should be able to capture a number of profitable trades.
High-Profile Retail Stocks Still Weak
On the retail side, there are a number of popular growth stocks that are tracing out major topping patterns.
Many of these names have held up well as the higher-end U.S. consumer has continued to spend. But as the economy grinds back toward a recessionary environment, these stocks are now coming under pressure.
We have been short COH for more than a month now, with half profits already taken off the table and a trend position continuing to run for the second half.
The luxury handbag maker sliced through a key support level last week before rebounding Friday in-line with the rest of the market. With partial profits already taken off the table, and 14% unrealized profits on the second half, we have the ability to give this trending position some elbow room, while still guaranteeing an even larger profit on the second half if we are stopped out.
LULU looks particularly interesting after breaking sharply below the 200 EMA last week, and then staging a half-hearted rally on Friday. If the stock can hold up for another session or two, we should have a good opportunity to enter with a relatively tight risk envelope and plenty of room for the stock to drop.
Heading towards the open, S&P futures are pointing to a flat start to the second quarter. Trading desks will likely be manned by second-string professionals this week as record heat and a holiday week gives most traders an excuse to hit the Hamptons early.
We're keeping our exposure light as well, and watching to see if the market's new strength has legs, or simply sets up better entries for our short candidates.
Disclosure: I am short COH. Also long WFC and USB