View From the Turret: Shakeout or Smackdown?

For the weekend warriors, checking the box scores over their Saturday-morning coffee, the action in the market was rather placid last week.  The S&P 500 gained 0.1%, the Nasdaq rose 0.4%, and the Dow lost 55 points – less than a half-percent.
But for those of us in the trenches fighting it out on a day-to-day basis, last week was much more action-packed.
On Tuesday, equity indices traded sharply lower as a confluence of international data points indicated that the global economic growth story wasn’t as robust as previously expected.
China downgraded its GDP forecasts, the European drama kicked back into high gear, and Brazil reported its second worst annual performance in nearly a decade.
The news came as a shock to institutional managers who had largely been positioned for a continuation of the “goldilocks” recovery (not to hot, not to cold…)  The action triggered a number of risk points for our existing trades, automatically reducing our bullish exposure, while also hitting entry points for a number of counterbalancing bearish trade setups.
Tuesday represented the busiest trading day we have seen in the Mercenary Live Feed in a number of months.
While we understood that the headline risk from Europe could quickly derail the “melt-up” environment for equities, it still made sense to continue with the bullish trend (with reasonable stops) until the music stopped playing.  As the environment quickly shifted, we adjusted our exposure accordingly.
Heading into the end of the week, equities started to recover from their slump – helped along by positive employment numbers both Thursday and Friday.  As we open a new week of trading, we now have to determine whether last week’s shakeout was simply part of the Wall of Worry that typifies bull markets, or if the sharp selloff was the first salvo in a much more ominous battle between the bulls and bears.
The Mercenary Portfolio is currently positioned with a bearish bent, and less exposure than we began last week with.  There are a number of key areas we have our eye on for potential trades as we work through this key inflection area…

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Financial Exchanges Back In Play
It’s been a tough few years for financial exchanges and clearing firms.  While trading activity has been fairly high, the risk levels for clearing operations (who guarantee both sides of most traditional AND derivatives trades) has been sobering.
Last year’s MF Global catastrophe dealt a significant blow to investor’s confidence in this business – a business that survives solely on “trust” that the system will work.  Our friend Peter Brandt had some valuable insight on how this bankruptcy and fraud situation could affect the long-term health of markets.
There have been other issues giving investors second thoughts when analyzing this market over the past year.  From a Thesis Notes posted in the Mercenary Live Feed last week:
Another damper on the industry has been the absence of any meaningful M&A (merger & acquisition) activity.  Last year  Nasdaq OMX (NDAQ) and Intercontenental Exchange (ICE) joined forces to try to take over NYSE Euronext (NYX).  The bid was unsuccessful but would have been an attractive deal in terms of cost synergies and potentially more integrated trading platforms.
This week, ICE’s US president was on record stating that his firm was looking for “large transformative deals” this year – an indication that M&A activity may pick up in 2012 – leading to a takeover premium for stocks perceived as targets.
With so much uncertainty in the area, institutional investors have largely avoided this group – leading to deep basing chart patterns for stocks in this area, and a largely bearish perspective on the group.  A shift in this one-sided perspective could trigger a long-term bull market for the group – and it appears the catalysts are already in place for a major shift…
As the Wall Street Journal reported this weekend, the London Stock Exchange’s bid for 60% of LCH.Clearnet could bring the group back into “elite” status – allowing it to compete more effectively with international rivals.  The transaction could also spark another round of consolidation – which typically leads to a takeover premium for stocks in the group that are perceived to be potential targets.
We’re keeping our eye on a handful of stocks in this group that have completed basing patterns on the weekly chart – and are now drifting sideways to set up attractive entry points with limited risk envelopes.

What’s Next For Treasuries?
Often, the most profitable trend opportunities take place after a long period of consolidation.  Long-term treasuries certainly fit that pattern after spending the last several months treading water following a new multi-year high.
During a period of high risk (and low short-term rates), demand for “safe” long-term treasuries has been very strong.  Considering the sovereign debt issues in Europe, institutional demand has been largely focused on US securities.  The Fed has been active buyers of long-term securities as well – hoping to push capital farther out on the risk curve to ignite economic growth.
But as the dynamics change, rates on treasuries are likely to rise (with a corresponding drop for prices) – due to less liquidity form the Fed.  Last week’s strong employment data certainly helps to create an environment for lower treasury prices and overall higher levels of risk taking.
Nathan O. (our in-house trend expert) has a pending short trade for long-term treasuries (see screen capture below).

A breakdown from this level could easily lead to a quick trade down to the low $90 price level.  At the same time, our initial risk point would be $116.80 – giving us an opportunity to capture 5-10 times the amount of capital we are initially putting at risk.
This is a great example of the power of trend opportunities.  When you are able to set up a trade with a high reward-to-risk multiple, even a 50/50 win-loss ratio can result in a tremendously profitable program.  Check out Nathan’s Global Trend Capture to see what other setups are on the radar right now.

The Private Equity Refinancing Boom
It’s been a long time since we’ve seriously looked at the private equity industry.  The group has been saddled with a significant amount of debt, and until recently its been difficult for private equity firms to capitalize on their investments by issing IPOs and liquidating portions of their holdings.
This weekend, the Wall Street Journal noted that demand for higher interest rates was giving private equity firms an attractive refinancing window – lowering debt service costs and giving PE companies more flexibility:
Yield-starved investors are fueling a wave of refinancings for some of the largest private-equity-backed companies that have struggled under debts they took on during the buyout boom that peaked five years ago.
The deals for new debt, often with later due dates, are buying time for private-equity firms to whip their money-losing or otherwise underperforming companies into shape so they can get a better payoff down the road.
~ Buyout Debt Lures Hungry Investors
The same speculative demand that is greasing the skids for debt refinancing is also creating a better opportunity for IPO transactions.  If PE firms are able to sell their holdings in a more speculative market, they stand to reap huge incentive allocations while simultaneously boosting the market value of their retained portions in these public companies.
From a technical perspective, a number of publicly traded private equity firms are looking much more attractive.  Fortress Investment Group (FIG) is working its way out of a multi-month base and could rally sharply as the company mends its balance sheet and liquidates portions of its portfolio.

This week will be important from a technical perspective as traders determine whether last week’s action was an isolated event or a more ominous red flag.
We’re more than willing to put capital to work in high reward-to-risk situations, while still respecting the price action and the potential for more choppy action.
Trade ‘em well this week!
MM