View From the Turret: Open Season

Earnings season kicks into high gear this week, with a number of key industry leaders releasing first quarter reports.
In addition to the flood of data on individual securities, markets will also continue to handicap the ongoing antics in Washington. Republicans and Democrats have been attempting to find an agreeable approach to cutting the federal deficit.
But the two parties are still miles from reaching a compromise.  Until a new plan is approved by Congress and signed by the president, traders have to adjust to new expectations for government spending and subsidies for various industries.
Internationally, the risks haven’t improved much over the last week.  Middle East unrest is still creating risk for international energy markets. European debt issues may be attracting less attention given the other risks in play, but another sovereign debt crisis could be just around the corner.
Even if the debt continues to be serviced, austerity measures will certainly challenge growth – and a widespread European recession (quite possibly a much more severe depression) would be felt by industry players around the world.
So with this challenging backdrop, it’s no wonder we are finding more attractive trading opportunities on the short side of the ledger.  As Mercenaries, we avoid long-term commitments to one side of the market – or to any particular industry or sector.
But given the fundamental risks and the technical weakness showing up in a number of charts, we enter the week with capital put to work on bearish opportunities, and an eye on additional opportunities as they set up.

Financial Confessional
Early this week, both Citigroup Inc. (C) and Goldman Sachs (GS) will issue their first quarter reports.     Both of these reports will have a material effect on the broad financial sector, as many of the issues affecting these two key players will be widespread issues for the entire industry.
For Citi, analysts are expecting earnings of 9 cents per share on revenue of $20.55 billion.  Both profits and revenue are expected to be sharply lower than the 15 cents and $24.42 billion reported in the first quarter last year.
Traders have not had much confidence in the international bank this year, and the stock price is still just a shadow of its pre-crisis glory.  We’re not expecting a particular setup for Citi at this time, but we do expect the earnings report to have a significant effect on the US financial sector.
Since we’re in the early stages of building short exposure in this area, we will be watching to see how the various money center banks respond to Citi’s announcement and possibly setting up new short trades where we see strong risk/reward setups.

On a similar note, Goldman’s report will likely have a material effect on the investment bank group.  On Monday, the company is expected to report sharply lower GAAP earnings due to a number of specific charges.  Adjusted earnings are still expected to be lower than last year as the environment has become more challenging.
Analyst expectations have been adjusted lower over the last three months, and trader expectations are following suit.  The stock is now decidedly below all key moving averages and if the March lows are broken, it would be an open invitation for momentum traders to begin rolling out more short exposure.


Momentum Reversal
When stocks that are held in size by most mutual funds begin to fall, it can be a bad sign for the overall market.  More importantly, it can be an incredible opportunity for traders willing to take advantage of the liquidation.
Apple Inc. (AAPL) has been one of the most loved and over-owned securities of the last generation.  Almost every self-respecting mutual fund manager has a significant chunk of his assets riding on the company, and the company continues to grow earnings by a healthy clip quarter after quarter.
But so far this year, stockholders have been relatively disappointed.  AAPL has basically etched out a broad head and shoulder formation, finishing last week at the lowest closing price so far this year.
On Friday afternoon, the Mercenary Live Feed called an audible, shorting AAPL as the stock broke through resistance.  The pattern looks ominous, and with so many investors and traders heavily committed to the long side, the drop could turn out to be both swift (in terms of time) and far (in terms of price movement).

Our friend Peter Brandt had similar thoughts in terms of the trade setup for AAPL.  More importantly, he sheds some light on the what we refer to as The Siren Song of High Winning Percentage.
From Peter…
When I see a great signal set up on a chart, I could care less what company it is or what its fundamentals are.  In fact, I could care less if I will be right or wrong in the trade — In truth, I assume I will be wrong (I am wrong about 65% of the time).  The only important thing to me is the risk/reward profile of the trade…
Successful market operations have little to do with correctly picking the direction of a stock — and everything to do with managing the relationship between risk and reward.
We’re keeping our risk point tight on this trade, and expect that a sustained decline would generate profits many multiples of our capital currently at risk.
If you would like to take a look at the Mercenary trading book and see our daily process for setting up trades and managing risk points, you can get a 14-day free trial here.
Bullish Setups for Biotech
Even in a bearish environment where risks are mounting, there are still industries and sectors that offer strong bullish trades with attractive risk / reward dynamics.
We have already mentioned the solar industry as an area that has attractive fundamental metrics and charts with attractive basing patterns.
The biotech industry is attracting investment capital and most ETFs that cover the area have developed bullish patterns.  But from a valuation standpoint, the industry still appears relatively cheap, considering strong growth expectations.
On Friday, the thinly traded PowerShares Dynamic Biotech and Genome (PBE) broke to a new high after forming an attractive cup with handle basing pattern.

A number of the individual components also look like attractive bullish opportunities and could represent an effective counterbalance to our existing short exposure.  Of course, price action would dictate whether we actually put capital to work in these areas, but the group is worth tracking for individual setups.
Celgene Corp (CELG) focuses on therapies for cancer and immune-inflammatory diseases and has developed a very profitable product line.
Over the last four quarters, the company has generated year over year sales growth between 30% and 40% and earnings have been growing impressively as well  Analysts expect EPS to grow by 21% in both 2011 and 2012, and yet the stock is trading at a multiple of less than 15 times 2012 earnings expectations.
After a meaningful consolidation since November of 2010, the stock has been rebounding and is now above key moving average support.  A break above April highs could signal the stock is ready for another bull run, and would likely attract momentum traders.

Gilead Sciences (GILD) had a very difficult year last year, with the stock losing more than 30% of its market capitalization.  But even during that time, the company continued to grow both revenues and earnings, building value while the stock price was declining.
This year, the story has been much different with the stock advancing and holding above key moving average support.  The stock trades for roughly 10 times expected earnings for this year, and analysts expect earnings growth to continue into next year.
On a long-term weekly chart, the pattern still appears to have plenty of room to rally.  The management team still appears committed to growth, and recently acquired private Calistoga Pharma for $375 million.

Heading into the week, our exposure remains decidedly bearish.  But that doesn’t mean that the bulls are without a pulse.
Over the past several months, we have seen stock prices supported despite mounting risks.  As nimble traders, we have to respect the possibility of another stand by bullish traders, while still positioning ourselves to profit should the bearish action continue.
This is the life of a Mercenary Trader.  We’re willing to change course when necessary, and we are diligent in constantly measuring our risk.
Trading through another earnings season, there will most certainly be plenty of volatility and shifting undercurrents.  But as a community of ruthless profiteers, we’re in this together and we look forward to booking collective profits along the way.
Trade ‘em well this week!
MM