View From the Turret: Knee Jerk Rally As Spain Requests “Credit Line”

June 10, 2012
By

Welcome to another week of European headline-driven trading!

Equity futures are materially higher as traders react to the news out of Spain. Two weeks ago, the Spanish Prime Minister claimed that the country wouldn’t need a bailout.

But over the weekend, Spain requested a 100 billion euro “credit line” to help prop up failing banks. The bullish argument is that this credit line will help provide stability ahead of the upcoming Greek elections.

Whether the knee jerk rally will gather momentum or not remains to be seen. Fundamentally, the bailout package is unlikely to alleviate the long-term risk – yet another attempt to push liabilities a bit farther into the future.

But even ahead of the weekend announcement, equity markets have been rallying from oversold areas. Midway through last week, it looked like the bear market rally had run into resistance levels and was ready to continue lower.

But bullish action to close out the week – along with a strong likelihood of a gap higher Monday morning – indicates more potential for a sustained bounce.

A transition back into a choppy environment requires a comparable shift in our trading approach as well. This type of action favors more aggressive risk management, and a willingness to grab swing profits quickly.

Of course, the fundamental environment is still full of risk (decelerating Chinese growth, European debt crisis, US unemployment etc) – so our “big game” opportunities for this year are still in play.

But with the short-term trading picture looking a bit more muddled, our High Probability Swing System will be driving most of our trading action this week.

Below are some of the areas we are focusing on over the next few sessions…

Biotech: Hunting Ground for Bullish Trades

Biotech stocks have been relatively quiet (and impressively stable) even as the broad market volatility has picked up.

The group has some interesting trading characteristics as the area can certainly be seen as a stable defensive sector (people are always going to need new medical developments), but also has some aggressive growth characteristics.

Looking specifically at the iShares Nasdaq Biotechnology (IBB) ETF, the sector has posted significant gains over the past two years, but has consolidated enough in 2012 to resolve the overbought price action – even on a monthly chart.

The ETF has a valuation premium above 20 times expected earnings – which is a relatively high number, but also representative of the long-term growth prospects for the industry.

Rather than take positions in small individual biotech stocks which have major risk associated with regulatory approvals for one or two specific drugs, we’re more interested in picking up exposure to well-heeled biotech companies with a number of established product pipelines.

This week we will be looking at individual biotech names from both a fundamental and technical perspective, and if the rally continues to gather strength, we’re likely to capture some profits as the industry resumes its bullish trend.

Homebuilders Breakdown Still in Progress

On the bearish side of the ledger, homebuilder stocks still look like excellent short candidates.

The group has rallied to a price level where valuations are now incorporating significant growth expectations, while at the same time, the domestic macro picture is becoming more challenging.

The payroll report for May was particularly troubling as the US economy added far fewer jobs than expected, and the actual unemployment number increased for the first time this year.

Sentiment for the group is being propped up artificially by low foreclosure rates as banks sit on inventory rather than flooding the market and depressing prices further.

The danger in this situation is that any time economic data points lead the banks to believe the environment is turning, there is more incentive to step up the foreclosure process, which floods the market with cheap existing homes that compete with new units being built by the homebuilders.

Of course, without improvement in the economy, homebuilders will continue to struggle as demand for new housing remains weak and the newfound bullish sentiment reverts back to a more realistic perspective.

We’ve been busy isolating the most vulnerable names in this group and should have a Strategic Intelligence Report posted over the next few days. In the meantime, take a look at the breakdown and drift back up into resistance for the iShares US Home Construction (ITB) ETF.

Ten hours ahead of the open for US Equities, S&P futures are pointing to a 1% gap higher and the euro is up nearly a full percentage point against the US dollar as well.

The action this week could take a number of different directions ranging from a complete gap and crap (total failure for the bulls), to a full-fledged ramp as retail and professional investors alike scramble and chase the price action.

Of course we also have to be prepared for muted summer action as the news can be “accepted” and then traders simply move on to the next issue…

The nice thing about being nimble is that we don’t have to rely on any one scenario to book trading profits. Each day, we can gauge the environment and adjust our style and parameters to adjust for risks and potential returns of the day’s situations.

Trade ‘em well this week!

MM (mike@mercenarytrader.com)

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p.p.s. If you haven't already, check out the Strategic Intelligence Report!

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