View From the Turret: Extension City

September 27, 2010
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David Tepper’s interview lit a fire under the bulls on Friday, leading to another jam-job higher.  The script is not all that unexpected given the improving sentiment and the assortment of bullish short-term economic data points over the past few months.

Up until Thursday, the weekly jobless claims had been showing modest improvement (fewer people being laid off but still an unbelievable number of people out of work) and last week’s FOMC statement featured another “all in” statement by Hellicopter Ben.

“The committee will continue to monitor the economic outlook and financial developments and is prepared to provide additional accommodation if needed to support the economic recovery and to return inflation, over time, to levels consistent with its mandate”

We currently have an interesting period where the broad market is showing more positive traction with improving sentiment.  However, the fundamentals behind the movement are suspect (we’re HAPPY because the FOMC feels the need to add more nitro to its liquidity injection?) and risk continues to be exceptionally high.

As traders, we have to continually be willing to shift gears when necessary – respecting the price action while not ever completely deferring to it.  Our current approach to markets has us sitting on a number of orders to short extended and vulnerable names, while also looking for opportunity to participate in long opportunities that have more fundamental justification for higher prices.

Short trades for extended “cult stocks” will be executed based on a volatility adjusted stop order when these stocks actually begin to trade lower.  Waiting for the first move has kept us from committing too much capital too quickly, and our tight stops are also a defensive maneuver to protect the initial capital.  Once these names begin breaking down in earnest, the reward to risk ratio should give us a significant edge.

On the long side, we are looking at solid sectors such as gold miners, fertilizer companies, uranium investments, and possibly taking a shot at a few solar names.  But in this environment, it’s fairly risky to buy range breakouts and we would rather make purchases after strongly trending stocks have backed off a bit and given us a good inflection point and are likely to continue the broad trend higher.

So let’s take a look at some of the trades we will be stalking this week…

Cult Extension Stocks

Shares of Ctrip.com Intl Ltd. (CTRP) are rallying sharply right into a resistance area from June.  The stock is a bullish proxy for the Chinese consumer in general and of course China travel specifically. Trading at roughly 50 times annual earnings with an expected 30% growth rate next year, it’s easy to see a scenario where investors could quickly become disappointed.

This summer over the course of just a few weeks, CTRP dropped more than 30% as investors began to question growth.  Those questions appear to be at least temporarily resolved, but if CTRP fails to pass the test at $47, we could see a rush of sellers heading for the exit and staying away this time.

Lululemon Athletica (LULU) is another widely held stock that is trading at a premium price with extremely hopeful expectations for growth.  We have taken a small initial position as the stock did not participate in the week’s retail rally and instead began to back off.  Our short stop order was triggered when the stock dropped sharply Wednesday on relatively high volume.

Lululemon is expanding rapidly in the US, but its focus on the high-end consumer has me doubting whether they can keep margins from contracting and disappointing bullish investors. The stock has rallied nearly 50% in just a few weeks (after dropping sharply in August and early September).  We’re keeping our stop tight, and the potential return if this trade is successful far outweighs the loss we will take if LULU once again joins the bull train.

Other extended candidates include:

  • Netflix Inc. (NFLX) which put up an incredible run this past week, but finished relatively weak on Friday.  The stock is trading at 58 times this year’s earnings and while growth is expected to be strong, that’s still a lot to pay considering the potential for competition, lower consumer spending, and changing investor sentiment.
  • Amazon.com Inc. (AMZN) which just crossed $160 on strong volume Friday.  Amazon has a multiple of 62 and expected earnings growth shy of 40%.  Any disappointment in guidance or analyst opinions could quickly lead to a moderate retracement and offer us a chance for a great entry as the stock breaks down.
  • Baidu Inc. (BIDU) also hit a new high on Friday and the stock is becoming significantly extended.  Sentiment on China-based investments has been notoriously fickle and so uncertainty coming from the Far East could trigger a selling spree until BIDU returns to a more “acceptable” earnings multiple.

Upside Participation

There are a few attractive sectors that look like good long candidates provided we can create entry points with appropriate risk envelopes.

The solar sector features some healthy companies that are generating strong profits with reasonable stock prices.  Sentiment is shifting and investors are more willing to believe that Chinese and European governments will continue to support the industry, and the margins on solar power are becoming strong enough to give the industry credibility on its own.

Renesola (SOL) is a good example of a company that is once again generating a healthy profit (expectations are for EPS of $1.44 this year and next) and the stock is still relatively inexpensive.  However, SOL is very extended and to fit into our risk / reward criteria, we would need to see a pullback and then signs of a continuation of the bullish trend before pulling the trigger.


Other solar names worth keeping on the watch list include JA Solar (JASO) which rallied an additional 5.6% on Friday, Trina Solar (TSL) which is experiencing a nice consolidation, but it’s a bit disappointing to see that action on days when the market is pushing higher, and LDK Solar (LDK) which broke out above a minor resistance area Friday on very strong volume.

If Tepper’s argument continues to work its way around the trading desks of Wall Street, we may see additional interest in oil E&P stocks which are a good proxy for economic recovery.

Many of the major names like Schlumberger Ltd. (SLB), Exxon Mobile (XOM), Chevron Corporation (CVX) etc. are beginning to look more attractive.  Whether the bullish argument turns out to be fundamentally correct or not, the stocks could quickly gain traction just from the idea that the argument is correct.  Remember, it’s not about being right but about making money. And in the short-term, there may be a great opportunity to make money on a rally in major oil corporations.

At this point we are looking at the Energy Select Sector SPDR (XLE), a broad proxy for the group.

With all of the cross currents in play, we can make a good argument for a sharp advance or decline depending on how the various participants act in the near-term.  So the key is to stay nimble, focused, and keep ego out of the equation.

Some days it’s about grinding small trading profits for position during uncertainty…  And other days we will get to bet big after earning the right and having the conviction to be more aggressive.  So keep the current uncertainty in mind when sizing positions and setting stop points, and we will continue to watch for the fat pitches as well.

Trade em well this week!
MM

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