View From The Turret: Aftershocks

It’s been a sobering weekend as we begin to understand the magnitude of devastation caused by the earthquake and tsunami in Japan.  From entire cities being wiped out, to nuclear power plants on the verge of meltdown, the human toll is difficult to comprehend.

On the economic side, the picture is also quite concerning.  Even before the quake’s devastation, we discussed the churning action – an intense battle between momentum bulls and newly energized bears.

This past week, the Nasdaq and the S&P 500 fell below their 50 day moving averages, a technical support line that has held up for more than three months for both the major indices.  Bespoke Investment Group notes that this was the first time in history that both of these indices have broken this kind of streak on the same day.

The statistical probability of further weakness is high as momentum traders are now becoming discouraged and emboldened bears are beginning to accumulate profits.  Despite Friday’s optimistic rebound, we’re still cautiously positioned alongside the bears, expecting more weakness in the weeks ahead.

As Jack noted over the weekend, the US consumer is still unlikely to be able to support an economic rebound, and improving personal debt figures are more a function of write-offs than healthy balance sheet repair.  For the trillions of liquidity pumped into the system, all we got was a mild economic recovery with plenty of caveats to worry about.

So as the indices begin to roll over and individual stock charts develop negative patterns, we’re positioning our book to take advantage of a flight to quality and a broad evacuation from more speculative areas.


Stability Attracts Capital

As the risk-off trade began to evolve in the last few weeks, we began looking for areas where managers would feel comfortable parking capital in a higher-risk environment.  On 2/24, the Mercenary Live Feed noted an opportunity setting up in the S&P Utilities Fund (XLU):

Utilities (XLU) have been trading constructively and could see a renewed safe haven bid, especially if bonds rise and rates again fall.

XLU actually trigged our long entry on 2/28 and quickly began accumulating positive returns.  This past week, the ETF hit our half profit target (HPT), giving subscribers to the Live Feed an opportunity to take some gains off the table.  We continue to tighten the risk point on our remaining shares, with an eye towards protecting existing profit while also giving the position room to fluctuate on its way towards building stronger profits.

If the broad market continues to roll over, areas of perceived safety and stability will likely capture a larger share of institutional capital, and we could see more bullish moves in areas typically perceived as “stodgy” and “boring.”

Dollar Rebound in Play?

Despite its many flaws, the US dollar is still perceived as a safe place to park capital in times of elevated risk.

Last week, Winston Wolfe outlined the potential for a US dollar short squeeze as traders appear to be caught with overly bearish positioning in the USD.  Renewed debt concerns in Europe (the risk seemingly cannot be swept under the rug) will likely be supportive of the greenback, and the US dollar index is sitting right on a significant area of support.

We’ve taken a long position in the dollar at what appears to be an important support area, and any strength this week could give us an opportunity to pyramid our exposure, adding to a profitable position.

Split Tape for Retail

Retail stocks have been trading in somewhat of a bi-polar fashion, with high-end luxury shops holding up well, and chains that cater to mid to lower income clients experiencing weakness.

This makes sense, considering the fact that consumers in these two groups are experiencing a very different flavour of economic recovery.  High-end consumers are much more likely to have been able to preserve their employment, and since many of these workers are being asked to shoulder a heavier load of responsibility, they may feel more entitled to splurge on spending.

The lower-income tier has an entirely different story.  Jobs have been cut while higher food and gas prices cut into discretionary spending levels.  For many, there simply isn’t enough income to cover all of the necessary expenses – not to mention the cost of eating out or adding to the spring wardrobe.

On Thursday, Lululemon Athletica (LULU) announces fourth quarter (fiscal year end Jan 31) earnings.  Since LULU is one of the ultimate “luxury apparel” names – and also a speculative growth vehicle – it will be interesting to see how traders react to the report.

If recent history is any indication, investors could be treated to yet another gap higher as the firm executes on its growth strategy.  But if management offers any disappointing guidance or negative profit metrics, the speculative price multiple could get knocked for a loop.  We’ll be keeping our eye on this report as it has the potential to change the trading perception for a number of other speculative growth names.

On the other side of the continuum, Target Corp. (TGT) caters to a less-affluent customer base and has been trading significantly lower this year.

If the bears win the battle for the broader retail sector (see XRT chart in Jack’s Weekender piece) retail names that have already established bearish trends could be great trading vehicles.

While Target is not particularly expensive – the PE ratio is near 13 – analyst expectations have been revised lower and very little growth is in the forecast for the next two years.  Compared to LULU, this chart shows a disappointing picture for retailers serving consumers with less discretionary income.

Technology Leadership in Question

For the majority of the last year, broad technology firms – and niche providers as well – have been attracting capital.  This makes sense because the economic recovery has been largely built on efficiency gains.  Productivity has continued to increase while hiring has been lackluster at best.  Investments in tech upgrades have allowed a number of corporations to grow operations with very little investment in human resources.

Today, a number of favourite tech companies appear to be weakening and could get hit by a broader “risk-off” move in the markets.  Since many of these names carry a high multiple and robust growth expectations, they are particularly vulnerable to a significant decline.

Of course, investor perceptions would have to shift dramatically to cause these multiples to contract – but we’re already beginning to see the momentum shift and some topping formations in place.

F 5 Networks Inc. (FFIV) has experienced a tremendous run over the past two years.  The company managed to generate earnings growth even during the challenging financial crisis periods and investors have rewarded good performance with a PE multiple approaching 40.

But over the last few months, the networking stock has begun to roll over and investors appear to be losing interest.  If we are entering a more sustained “risk-off” environment, then high-growth, high-multiple names like FFIV could face much more pressure and significantly lower prices.

90 minutes before the open, S&P futures are 9 handles lower.  This only represents a portion of Friday’s rebound, but given the elevated levels of risk, we are comfortable with our bearish posturing.

Quake damage reports continue to be revised with nuclear reactor meltdown threats a significant concern.  We also have a fed meeting and various economic reports to analyse this week, so expect plenty of volatility.

We’re locked and loaded and ready for another important week.

Trade ’em well!


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