By Mike McDermott
As the second quarter earnings season winds down, equity markets are embracing a more bullish tone. Not only are the large-cap blue chip averages continuing to grind higher, small-cap stocks along with transports are now confirming the advance.
A few weeks ago, the bullish argument centered around expectations for another round of quantitative easing from the Fed. More recently, however, the bulls have flipped the script, with confidence increasing due to moderate improvement in U.S. economic data points.
Of course, this positive data may give the Fed pause to implement new stimulus measures, but for now, traders are focusing on the positives. An absence of disturbing headlines from Europe and a sense of relief from surviving the Q2 earnings season are helping to boost sentiment.
From a technical perspective, there are a number of indicators confirming the bullish action:
- U.S. Treasury prices declining - As confidence improves, capital is rotating out of "preservation" mode into growth opportunities. Lower treasury prices of course correspond with a lift in "risk-free" interest rates.
- Rotation out of defensive sectors - Long-only managers with a mandate to stay fully invested have loaded up on utilities, consumer staples, stable dividend stocks. Now, institutional investors are scaling out of those positions in favor of cyclical high-beta vehicles like homebuilder and tech stocks.
- Low volatility supports "grind higher" environment - A low VIX reading is often associated with a market that is topping, but historically speaking, volatility readings can remain low for an extended period as the "fear indicator" remains low and equities continue to grind higher.
As equities continue to advance and the risk of an earnings-driven selloff fade, institutional managers are now facing the challenge of keeping up with their benchmarks into year end.
The problem with underweighting risk assets is that managers who were conservatively positioned heading into earnings season are now behind the ball. And in an industry where positive relative performance is the difference between employment and a pink slip, there is a strong incentive for portfolio managers to ratchet up their risk in order to charge returns.
We're heading into the week positioned as cautious bulls - with a growing number of long positions and a number of sectors on our radar for new trade opportunities.
Below are a few areas we're focusing on this week:
Solar Stocks Rebounding From Deep Value Levels
The alternative energy area has been a challenging place for investors to make money for several years. Overcapacity, lower fossil fuel prices, and compressed profit margins (to the point of being negative in many cases) have pushed equities lower for years.
It appears that the industry is finally approaching equilibrium, with under-performing companies being taken off line or bought by competitors, and the remaining firms enjoying the benefits of a rebound in both oil and natural gas prices.
Solar energy stocks have traded down to valuation levels that imply little to no growth, along with a high perceived risk of bankruptcy. Value investors are now making the argument that stock prices fully incorporate the risks, but fail to account for the prospects of the industry actually surviving.
Over the past three weeks, we have seen the broad group move higher and break through key moving average resistance. Last week, we took a starter position in the group as documented in the Mercenary Live Feed.
As the bullish action continues, we will be looking to add horizontal exposure to the position - branching out into individual equities that offer strong technical setups and a compelling fundamental story.
First Solar Inc. (FSLR) is a strong candidate based on the fact that the stock is trading at less than 5 times projected profits for this year. The company has remained profitable throughout the devastating bear market for the solar industry, and yet its stock price has fallen dramatically.
In 2008, the stock peaked at $317, and even 18 months ago, FSLR hit $175 per share. Today, we can pick up shares just above $21, despite the fact that the company will earn more than $4.00 per share both this year and next.
From a technical perspective, FSLR is leading the industry higher, having bottomed nearly two months before the industry began turning higher. The stock has cleared an initial resistance area on strong volume, indicating significant buying pressure from both retail and institutional investors.
A new bullish position with a relatively tight risk point would offer a strong reward-to-risk scenario. FSLR could easily trade into the mid $40′s before hitting significant technical resistance, and still offer a compelling value for long-term investors.
Gold Miners Benefit From Growth Expectations
As prospects for economic growth improve (or perception leans more towards a growth scenario), inflation expectations also come into play. Considering the likelihood of additional injections from the Fed - and potential printing from the ECB - the prospects for a gold rally are good.
Already, we have seen gold and silver prices stabilize, and the price action is likely to improve as economists incorporate positive employment and export data points.
Junior gold and silver miners should offer the best reward-to-risk trading opportunities as these companies have the most to gain from rising commodity prices, and typically have the highest beta in relation to precious metal spot prices.
Last week, the Market Vectors Junior Gold Miner (GDXJ) ETF confirmed its recent break above the key 50 EMA - this following a basing pattern where a support level between $17 and $18 was tested multiple times.
We're watching the area closely as a massive capital re-allocation into the area could significantly move prices for individual gold miner stocks.
Many of these miners are trading at depressed valuation levels as investors have become disenchanted with spot metal prices. Couple that with institutional investors' need to catch up with their benchmarks and you get an environment that could be explosive for gold mining stocks.
As investor sentiment improves and traders react to positive macro data, low yields for fixed income investments and blue-chip dividend stocks are becoming less attractive.
Investors are increasingly allocating capital to areas with strong prospective growth - which accounts for the strength in homebuilders, technology stocks, and other secular growth areas. You can see the degree to which investors are embracing risk by scanning the Live Feed Trend Tracker.
As traders, we have to be aware of these capital flows (taking advantage of the best reward-to-risk scenarios), while still respecting the significant risks in play. There are still a number of catalysts that could quickly send this rally into a tailspin:
- A deteriorating environment in Europe where default risk is once again in play.
- A post-QE3 depression where traders buy the rumor and sell the news (similar to post-partum depression?)
- Renewed concern heading into the Q3 earnings season as lower revenue trends from the past quarter result in lower EPS this time around.
Most of these catalysts would likely come into play in a mid-September time window, which leaves equities free to continue the grind higher for a few more weeks.
We're comfortable holding our modest roster of bullish positions and adding more exposure selectively. As the action continues, we'll adjust our risk points and continue to keep a wary eye on the exit door.