View From The Turret: September Trading Introduces New Risk For Bulls

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 |  Includes: DECK, EEM, FXA, MO, NKE, ROST, SHOO, TJX
by: Mercenary Trader

With the summer officially over, traders are returning to a challenging environment.

Equity indices are within striking distance of 52-week highs, having spent the summer grinding higher on incredibly light volume. At the same time, the global economy is teetering on the brink of recession, with a number of serious macro risks lurking.

The political spectrum creates just as much uncertainty as the economic picture (can one really separate the two?) as politicians around the globe struggle to come up with credible solutions to the various situations.

In Europe, Germany is now entering a recessionary environment, and yet the country is expected to be instrumental in bailing out their debt-ridden neighbors. Chinese politicians have limited resources to fight an increasingly likely hard landing. And in the US, the Fed is trying to determine whether another round of quantitative easing would be worthwhile.

Sentiment has been steadily moving higher with AAII (American Association of Individual Investors) readings now decidedly bullish. The Barron's cover story this week "Tough as Teflon" depicts a bulletproof bull, and the market's lethargic price action has essentially lulled investors into a state of complacency.

Ironically, confidence levels have risen despite the fact that markets have not broken to new highs. While the short-term path of least resistance still favors the bulls (a grind to new highs is still a high-probability outcome), a bearish break is still very much in the cards.

Moreover, while a grind higher environment offers modest profit opportunity for traders, a major price dislocation would catch investors off-guard and could lead to tremendous trading opportunities for the bears, as fearful investors and traders try to reduce exposure quickly - in a period of extremely low liquidity.

We're entering the new month with moderately bearish exposure, given the asymmetrical reward-to-risk profile of the current environment. We still have plenty of room to add additional exposure, whether through traditional equity trades, futures or forex positions, or structured option setups.

We're looking forward to the new month of trading, with the potential to break out of this listless environment of low volume, low volatility price action. Below are a few of the areas we are focused on for the week ahead…

Emerging Markets Moving From Bad to Worse

The global economic slowdown is hitting emerging markets especially hard…

With demand from developed markets under pressure, the export-based emerging market economies are struggling to maintain growth levels.

Given the heavy infrastructure investments that many of these countries have made (such as entire Chinese cities built and yet to be populated) the global slowdown comes at a particularly challenging time.

While US equities have been steadily advancing, emerging market equity indices have been severely underperforming. We are currently short the iShares MSCI Emerging Markets (NYSEARCA:EEM) with unrealized profits already built into the position.

Any stall for US equities would only exacerbate the situation for emerging market equities, as a flight from risk assets would certainly include additional liquidation of emerging equities as well.

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The ripple effect from slowing developed countries, to emerging markets, also extends to resource-rich Australia.

We've been discussing the danger to the Australian dollar for some time now, booking profits earlier in the year on a short trade, and building a material short position in the currency again over the last few weeks.

Our position (as documented in the Mercenary Live Feed) is in the AUD/USD currency pair which allows for very efficient use of capital in expressing the trade. The Currency Shares Australian Dollar (NYSEARCA:FXA) - or related option contracts - can also get the job done, but these securities require significantly more capital per unit of true exposure.

At any rate, the price action in the Aussie is once again turning south with plenty of potential for acceleration as we enter September. Just a few months ago, the AUD/USD pair was trading in the 0.96 range, and in 2008, the pair hit a low near 0.80.

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Dividend Plays Overvalued and Sinking

Last week we talked about how investors' reach for yield has pushed prices of utility stocks to vulnerable valuations.

Both retail and institutional investors have migrated to equities that pay high dividends, which is a direct result of the Fed's zero interest rate policy - leading to high fixed income prices, and correspondingly low yields.

In addition to utilities, many consumer staple bellwether stocks are also trading at high historical valuations, and heading lower as fixed income yields start rising (adding more competition for yield-oriented capital).

Altria Group Inc. (NYSE:MO), the former Philip Morris, is a great example of an over-valued dividend stock - now heading in the wrong direction. The stock pays a 5% yield, but also trades at nearly 15 times earnings. This is the type of multiple you would typically see from a stable growth company - not a mature cash-cow operation.

As interest rates begin to edge higher, and both corporate as well as treasury security yields follow suit, investors will have to weigh the additional risk of holding equity (versus debt), and determine if the additional income from dividends justifies the underlying capital gain / loss risk.

Altria's chart looks particularly ominous after years of steadily trending higher. Last week, we initiated a new short position after the stock broke down and then briefly drifted higher.

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'Safe' Capital Rotating Into US Domestic Stocks

As the global economy downshifts into neutral, and emerging market valuations continue to drop, portfolio managers are looking for stability in US domestic stocks.

Large-cap multinational companies may offer broad diversification, but with weakness around the world, this diversification winds up being a liability rather than an asset.

Ironically, this trend favors niche US small and mid-cap stocks that operate stable businesses and can demonstrate the ability to grow even in this challenging environment.

The retail apparel group has been a mixed bag lately in terms of stock performance. Stock prices for a number of over-valued retailers have dropped as brands have fallen out of favor, while other retailers such as TJX Cos Inc. (NYSE:TJX) and Ross Stores Inc. (NASDAQ:ROST) have continued to push to new highs.

More specifically, the footwear area has been improving in recent months as evidenced by a 33% rise in Steve Madden Ltd. (NASDAQ:SHOO) as well as a 15% rebound for Nike Inc. (NYSE:NKE).

One potential bull candidate on our roster is Deckers Outdoor Corp. (NYSE:DECK). The company has several well-respected footwear brands, and generates more than 2/3 of its revenue in the US.

DECK is currently trading at a single digit forward P/E (listed at 9.43) with an expected growth rate close to 19%. The stock has rebounded 25% from its July low, but still sits at less than half its valuation from late last year.

As capital rotates into safe domestic plays - companies that are generating strong cash flow and have reasonable valuations - Deckers should continue to rebound, advancing significantly before raising any red flags for value investors.

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Precious metal prices, along with stock prices for PM miners, have been moving sharply higher over the last few weeks.

Despite the recent strength, we're skeptical of the action and remain on the sidelines. The precious metal advances are largely fueled by expectations for additional liquidity injections (from both sides of the Atlantic), and are certainly helped by the tailwind of a weakening US dollar.

But taking an objective view of the situation, it's difficult to see how the Fed could justify a massive liquidity program with equities hitting new highs, and the presidential election just around the corner.

This isn't to say that there won't be any action during the Fed meeting later this month, but the magnitude of any announced program could turn out to be underwhelming - sparking a sharp selloff for precious metals. Considering this risk, the current rally looks quite dangerous and we're content to watch the action from afar.

In terms of catalysts this week, traders will be particularly attuned to the ADP and August payroll reports - scheduled for Thursday and Friday mornings respectively. We're still in a situation where bad news could be perceived as a positive (forcing the Fed's hand), while continued improvement in the job market could raise concern for the bullish camp.

We're locked and loaded with our bearish exposure in play and our risk points giving positions some wiggle room but keeping our total risk in check.

Trade 'em well this week!

Disclosure: I am short EEM, MO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Short AUD/USD.