After an extended period of benign and largely bullish market action, the tectonic plates are beginning to shift.
LOLO investors (Long Only, Leveraged Outright) are suddenly confronted with the reality of a two-way market, and the concept of “risk” once again matters when it comes to allocating capital.
On Friday, the Dow dropped 166 points – good for a 1.4% drop, and more volatile indices like the Russell 2000 dropped as much as 2.5%. Of course, the iShares Emerging Market Index (EEM) lost more than 3.1% as skittish traders quickly reversed their sentiments on international growth opportunities.
Barron’s had an unintentionally tongue-in-cheek statement regarding the resurgence of volatility:
“With street protests rocking Cairo and other capitals, investors must rethink their assumptions about markets’ vulnerability to risk.”
to which I might add: “or maybe those assumptions shouldn’t have been made in the first place…”
At the beginning of the year, Jack commented on Niels Jensen’s twelve major risks for 2011. The point was not to speculate which one(s) of these risks will actually come to fruition, but rather to point out that even with low probabilities for any ONE particular event occurring, the cumulative effect of a number of low probability events can actually lead to a much greater chance that something will happen to disrupt the low-volatility bullish chug higher.
When traders turn a deaf ear to these risks, the situation becomes all the more dangerous. The long side becomes more crowded, trends become extended, and valuations become excessive. In such an optimistic environment, it doesn’t take much to spook the herd – and send everyone running for the exits.
At that point, it’s just a matter of how much chaos is necessary to flush out the system.
The Mercenary Portfolios handled the Egyptian disruption in stride, with our relatively bearish positioning sparking profits – and our watch list flush with new breakdown opportunities. Of course there are also a few niche bullish ideas that could flourish in the newfound uncertainty.
So let’s dive into the setups for this dynamic upcoming week.
Emerging Markets Feel the Sting
There’s nothing like an international crisis to make investors think twice about allocating capital to emerging markets. But the emerging market dominoes were actually already lined up and vulnerable before the Egyptian crisis began.
Rising food costs and currency manipulation had already created a tinderbox that was beginning to smolder. The quote below is from the Mercenary Live Feed archives before the market opened Thursday:
In new setups today we have a potential short of EWZ, the Brazilian iShares ETF. Brazil has been on the forefront of the anti-$USD “currency war,” hiking interest rates aggressively and implementing moderate capital controls. EWZ, INP, EEM and others show how the bloom is off the rose for emerging market investors and a medium-term top may be in place.
Before the close on Thursday, EWZ triggered our stop/limit order and we shorted the ETF at $74.46 (all trades time stamped and archived in the Mercenary Live Feed.
The action on Friday simply added fuel to the fire, and sent EWZ plummeting. At this point, we have moved our risk point to breakeven and with any continuation, we expect to take half profits on this trade.
Fear Premium For Energy
Of course, while the unrest in Egypt is a major risk for domestic and even global economic expansion, the actions are very bullish for oil prices which surged on Friday.
The potential for much more widespread turbulence could disrupt energy supplies and serve as a further catalyst for what was already a bull market for oil prices.
A push back above $92.50 for crude would create yet another set of higher lows and higher highs – confirming the positive trend. And with currency debasement already acting as a tailwind behind a broad assortment of commodities, it’s easy to see how the bullish trend in oil could accelerate.
There are a number of ways to trade this trend including crude futures, the iPath S&P Oil Total Return Index (OIL), the United States Oil Fund (USO) as well as traditional E&P (exploration and production) equities and a number of alternative energy opportunities.
Hess Corp (HES) is a global driller whose reserves could quickly add value for shareholders as prices rise. The stock is reasonably priced based on earnings trends, and the company has a very manageable debt load. Investors have already begun building positions in the stock, driving the price from a short-term low near $50 in mid 2010 to its current level above $80.
A recent consolidation gives traders a chance to buy on a clear break higher, while creating a risk point near the low of the recent pullback. If HES has stable supply lines from production locations outside the Middle East, it could recognize a premium price and traders are already placing their bets on stronger profits.
If Middle Eastern oil supplies are cut off, companies with non-traditional oil production will likely catch traders’ attention. Canadian Natural Resources (CNQ) has developed expertise in oil sands production and the stock is rallying with bullish energy prices.
With significant production in areas outside the Middle East, and a technology edge above its peers, CNQ makes a compelling long-term investment case. Of course as swing traders we are looking for a catalyst and clear chart validation for entering a long position.
The stock recently pulled back to test its bullish trendline, and Friday’s action once again confirms that the bulls have control. With a solid fundamental base, and Egypt acting as the catalyst, a bullish trade with tight risk point should give us a good shot at large trading profits with our risk carefully managed.
Denison Mines Corp. (DNN) is one of very few opportunities to participate in the uranium market. With emerging markets as well as the developed world increasingly turning to nuclear energy, uranium stockpiles will quickly be used up. Spot prices for the nuclear fuel have been ramping, and the Middle East fear premium only adds to this trend.
Denison is growing revenue at an impressive rate and is expected to post its first profitable year since 2003. More importantly, the value of its underground reserves continues to increase with the depletion of global uranium stockpiles and the prospect of more reactors coming online.
The stock has been consolidating below $3.60 for several weeks now and a breakout would present an attractive buying opportunity.
Precious Metals Once More Attractive
The hallmark of a good trader is the ability to be nimble and flexible as market forces shift. Midway through January, we noted a reversal of fortune for precious metal stocks, and placed our bearish bets on a sharp pullback. The trade ran counter to the broad sentiment, as traders had recently increased their commitment to the PM area – and the environment was looking quite frothy.
After taking half profits on the majority of our bearish PM positions, we tightened our risk points to lock in profits on the remaining shares. Friday’s action indicated that this pullback was likely complete and we called an audible, closing our remaining bearish positions.
At this point, gold and silver miners could represent a flight to safety – and a place for institutional managers to park capital. Many fund managers are required to hold long exposure, but want to protect their capital from risk in traditional industrial or economically sensitive holdings. Gold and energy positions represent a great alternative and could once again attract a significant amount of capital flows.
This week we like the Market Vector Gold Miners (GDX) because the large-cap index will be viewed as more safe and stable – as opposed the the speculative junior gold miners. In months past, speculation on gold prices was the major driver behind the precious metal boom.
But today, buyers are looking for stability and preservation of the real value of their capital. This argues for a stronger surge in the blue-chip miners, and we’re watching GDX closely for an opportunity to step in.
Base Metals and Australia
Base metal producers have been running into resistance for several weeks now as commodity bulls take a break, and the rate of global consumption is called into question. If emerging markets take a break or simply slow the rate of infrastructure projects, spot prices for copper and iron ore could take a hit.
Last week we took a short position in BHP Billiton Ltd. (BHP) as the stock broke the 50 EMA and traded through the low of its recent consolidation. In addition to growth fears in China, the new Middle East tension makes for an even more uncertain environment. Considering the run that stocks like BHP as well as Rio Tinto (RIO), VALE SA. (VALE) and others have experienced, a significant pullback could be in the cards.
If base metals weaken, that’s bad news for Australia – a major producer of natural resources. Already reeling from recent floods, a drop in base metal pricing could be a huge challenge.
The Australian dollar index has been consolidating just below $100 for several weeks now and if it turns lower, it could pick up momentum quickly.
There are a number of ways to trade this trend reversal including the forex markets, currency futures, the Currency Shares Australian Dollar Trust (FXA) as well as option contracts.
With international uncertainty as well as a number of key earnings reports, this week is sure to be full of twists and turns. Flexibility is key as we react to the shifting dynamics.
Stay nimble and fluid!