View From the Turret: Emerging Risk

December 12, 2011
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Welcome to a new week of trading…  The last full week of trading before holiday schedules begin to cut into market hours and liquidity…

Once again, we find ourselves at a critical juncture with the major indices testing overhead resistance, and the drama in Europe adding plenty of volatility.  The headline nature of these markets is enough to drive a swing trader nuts – which underscores the importance of having a flexible approach to idea generation – while still maintaining rigid risk control to keep capital intact.

This week will prove to be an interesting period as traders adjust their exposure to ride out the holiday period, long-term investors revisit forecasts for the next 12 months, and many institutional investors are forced to rebalance based on year-end contributions or withdrawals.  Price action will be influenced by seasonal logistical decisions, but there are also plenty of fundamental forces that are shifting.

Last week’s data out of China showed renewed emphasis on growth (with inflation seen as less of a problem).  Earnings warnings from blue chip companies Dupont (DD) and Texas Instruments (TXN) raise concerns for developed market growth.  And of course the never-ending saga of fear / euphoria from Europe continues to toss investor sentiments back and forth like a rowboat in the high-seas.

This week, there are 11 new IPOs expected to price on US markets – including the social gaming company Zynga Inc. (ZNGA).  As noted in the most recent ETF Scorecard, the social media area is attracting plenty of attention, but the hype is wearing off quickly.  ZNGA is only expected to receive $10 per share (at the high end of the expected range) – compared with the most recent round of private financing that valued the company at $14 per share.  The pricing and subsequent trading will help clarify the overall investor demand for social media stocks…

With overhead resistance close, and fundamental risks mounting, we continue to approach the markets from a cautiously bearish perspective.  Below are some of the areas we are watching closely this week…

Emerging Markets Decelerate

China’s robust economic growth has been in danger of decelerating for some time…  But now, Chinese policy makers are beginning to acknowledge the weakness and shift their focus more towards stimulus and away from fighting inflation.

The largest concern at this point appears to be a decline in housing prices in a few key cities.  Remember, up to this point China has been very concerned about a rapid increase in the cost of housing as real estate speculators have driven prices up to unsustainable levels.

Policymakers are now walking the tightrope of trying to maintain “stable” growth, while still being vigilant about containing inflation.  Manufacturing statistics are also showing a deceleration of growth which gives the powers that be more room to be accommodative. But the real question is whether robust growth can continue with much of the developed world in some form of debt crisis.

China is by no means alone in walking this tightrope.  On Friday, India’s growth outlook was cut and economists warn that India has little room to add stimulus without significant inflationary risks.

The iShares MSCI Emerging Market Index (EEM) looks vulnerable with a series of lower highs.  Emerging market indices are losing relative strength to more developed indices – this despite the debt crisis that is hanging over Europe and to a large degree the US.  A breakdown from this point could signal that another leg lower is in play – and would be another warning sign for long-term investors to bail out.


Grain Supplies Pressure Prices

Remember when grain prices were skyrocketing?  All of the elements were in place for the perfect bullish storm:

  • Emerging market demand ate into supplies (no pun intended)
  • Droughts and floods led to declines in production
  • Biofuel projects allocated supply that would have otherwise gone to food stocks
  • Traders and speculators hoarded supply to capitalize on rising prices

But today, those dynamics have shifted.  Over the weekend, the Wall Street Journal reported record output expected for grains in the US.  Higher supplies in the US are exacerbated because overseas demand for grain has decelerated.  In short, the perfect (bullish) storm for grains has reversed and we’re seeing bearish price action for the entire asset class.

Our new trend following service – The Global Trend Capture – has a short position in both PowerShares DB Agriculture Fund (DBA) as well as the Teucrium Corn Fund (CORN).  Make sure you sign up for your 30-day Free Beta Test before the window closes at the end of the day tomorrow…

As prices continue to fall for wheat and corn, it will be interesting to see the overall effect on both importing nations who will benefit from a supply glut – as well as countries like Brazil that rely on strong grain prices to help bolster their exports.

Deep Value Bull Setups

While the current environment offers strong reward-to-risk scenarios for bearish trades, we still have our eye on a number of bullish setups that are in various stages of development.

In many cases, deep value candidates – trading at a steep discount with significant fundamental challenges – offer some interesting turnaround opportunities.  The Mercenary Live Feed has taken a modest long position in the Guggenheim Solar Energy (TAN) ETF as a proxy for solar energy.

The solar industry has been one of the more spectacular failures this year as oversupply, failed government stimulus programs, and plummeting demand from Europe has added huge pressure to companies operating in the area.  At this point, investors appear to have priced in all of the negative information, without factoring in any potential for the industry to survive the challenges.

We’re holding the ETF at this point instead of making any individual bets on single companies.  The chart for TAN appears to have found support and our potential return is large compared to the amount of capital we are risking.  Once a rebound is confirmed for the sector, we can then begin to add horizontal exposure to the position by picking individual stocks.

As we head into the week, bear in mind that Friday is options expiration – and we are also heading towards the holiday period where volume is low and the action can become unpredictable and choppy.

Manage risk carefully and make sure that you are aggressively protecting your capital.  While we are still willing to pull the trigger on opportunities into the end of the year, we want to make sure we start 2012 out with our trading account intact and plenty of dry powder for new setups.

Trade ‘em well this week!
MM


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