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Market Outlook for the week of July 6th 2008
The holiday-shortened week proved to be anything but uneventful. A combination of weak economic reports, another record for crude oil prices, and a complete lack of buyers in the market led the broader indices to new lows for this bear market. However, the highlight of the week was no doubt the stunning breakdown of commodity-related stocks on Wednesday and Thursday. The main culprits were coal and steel stocks, as spot Coal prices on the European exchanges plunged by more than 10% on Wednesday, which dragged down the high-flying stocks along for the ride. The charts of pretty much all the names in these sectors look similar; however let’s take a look at Alpha Natural Resources (ANR) as an example, which had been one of the best performing names this year, and especially over the last few months. Through the end of June, this stock was up +221% on the year and +115% just since the start of May. At one point intra-day on Thursday, the stock was off 22.9% just from the close on Tuesday, June 30th:
Even as crude oil and natural gas prices continued to make record highs, the majority of names in these sectors (in addition to agriculture) couldn’t withstand the selling pressure either, and we saw large corrections in oil/gas producers as well. While it’s tempting to think that this signals the start of the commodity “bubble” bursting, we are more inclined toward the belief that this is just a much-needed technical correction. Coal supplies, especially metallurgical coal used in steel production, are still extremely tight and as crude and natural gas prices continue to rise, coal is increasingly becoming the most cost effective input for electricity production.
It’s also important to remember that last week was the start of the new quarter, and investors/funds which have seen 50%+ returns on names in these sectors (energy/agriculture) were not surprisingly looking to take some profits off the table. Sector rotation was on full display as we saw renewed interest in sectors such as Biotechnology, Utilities, and Discount Retailers.
Last week we laid out arguments both for a continuation of the current downtrend and the possibility of a bounce off the oversold levels in the broader market. While the S&P 500 made a new bear market low (both closing and intra-day), we are at extremely oversold levels on every broad market index, the breadth indicators are at extreme lows and continue to fall, and short interest continues to rise to record levels. These are some of the factors that led us to believe that we were due for a bounce in the near term. However, daily market price action continues to be almost exactly negatively correlated to the price of oil, and if oil prices continue to rise without any significant pullback it will be extremely difficult for stocks to gain any traction. Remember, stocks can stay oversold for a long time. This week should be very telling as far as short-term market expectations, as we will see very quickly if investors will look to come back from vacation seeking value in beaten down sectors:
The week ahead
Earnings: The post-holiday week will be very light on reports as 2nd quarter reporting begins – the focus will certainly be on Alcoa and GE, as those were the two big disappointments at the start of last earnings season.
Tuesday – Alcoa (AA), Pepsi Bottling Group (PBG)
Wednesday – International Speedway (ISCA), Shaw Group (SGR)
Thursday – Marriot (MAR), Texas Industries (TXI)
Friday – Fastenal (FAST), General Electric (GE), Rockwell Collins (COL)
Economic Data: Not much data to move the markets this week, but we’re watching retail sales to see the effects of the fiscal stimulus package and whether any retailers outside of discounters – Wal-Mart, Costco, Big Lots, etc. – have been able to benefit from the rebate checks:
Tuesday – Pending Home Sales, Wholesale Inventories, Consumer Credit
Wednesday – Crude Inventories
Thursday – Weekly Unemployment Claims, Import/Export Prices, Trade Balance, June Retail Sales
Friday – Michigan Consumer Sentiment, Treasury Budget
Strategy/Outlook:
As you know, over the last few weeks we have been avoiding most energy stocks because of the heightened volatility. That proved to be a worthwhile strategy as even names that broke out to new all-time highs earlier in the week broke their up-trends and would have stopped us out on the long side.
While we have been monitoring a lot of names for short trades in these sectors, the risk/reward just wasn’t good enough for high probability opportunities. However, we feel a long/short combination is in order this week to take advantage of the recent pullbacks.
While there is a definite possibility of a short-term bounce in the broader market as we mentioned above, until institutions are willing to step in and spend some of their cash hoard to find value in beaten down sectors, this downtrend will most likely continue unabated. Even with the possibility of a bounce, we are very leery of going long financial institutions, homebuilders, or consumer discretionary names until there are clear signs of a bottom.
Therefore, we will continue to seek out long trades on names in up-trends that continue to make new highs combined with short trades on weak names which are failing to attract any buyers. Because of the heightened volatility and the ever-present possibility of sharp rallies, we will also continue to tighten our stops and look to take partial profits on winning trades to lock in some gains.
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