• SDS     +6.51%
• DTO    +1.00%
• VXX    +9.72%

Remember these positions all represent net short market trades and are to be used only within an acceptable range of risk. These vehicles are all very volatile, so we highly recommend readers to subscribe to our “Complete DS Analysis” feed in the right sidebar and our DS SHOUTBOX trading notebook feed @http://twitter.com/ds_shoutbox. The DS SHOUTBOX will give readers notifications of any trades made after the close of each trading day, while real time trade alerts are only available to private clients.

If you are interested in becoming a private client, feel free to email our Lead Trader and Analyst Robert Eberenz at Robert.eberenz.iii@gmail.com.

VXX (iPath S&P 500 VIX Short-Term Futures ETN), 1-yr chart on 05-28-10

Trade: Short the S&P 500

Time Horizon: 5-20 Trading Sessions

For the first time in a LONG time it’s becoming safe to bring on short positions relative to the S&P 500 equity index. The S&P 500 p/e ratio adjusted for inflation remains above 20 @ 21.13 as of Friday’s S&P 500 close @ 1089, which suggests that the recent correction on the S&P has further to decline before it reaches fair value.

SDS (ProShares Ultra-Short ETF), 6-mo Chart on 05-28-10

While we don’t feel comfortable going long the S&P 500 at any p/e level above 15, given the trend of rising interest rates, we understand that risk takers will re-enter the market at higher current p/e valuations. So we’re recommending this play as a short term position (i.e. 1-4 weeks or until reaching our profit target). Using the ProShares Ultra Short S&P 500 ETF (SDS) we can get relatively liquid 2x inverse exposure to the S&P 500 (recently +50 million shares/day). While we’re looking to capitalize on instability and unresolved risks in the EU, trading the SDS will give traders short exposure to a basket of U.S. equities and avoid short term fluctuations  in similar vehicles tied directly to the EU.

Trade: Short Crude Oil

Time Horizon: 5-15 Trading Sessions

We made a call to short Crude at $79.69, calling a price target of $70 /brl for the WTI continuous spot price and we cashed out when the WTI price hit that level. After closing that position at a profit, our hunch was confirmed. The uptrend in inventories had fought the rumors of accelerating demand for gasoline and mediocre distillate consumption, and instead that macro-economic and geopolitical forces are now leading prices.

WTI Continuous Crude Spot, 1-Yr Chart on 05-28-10

You may notice that the MACD histogram would disagree with our position, however the flight from risk trade is back on and we are going against our technical instincts to put an opening stake into DTO at 75 bucks. We also have a buy trigger set at $80/shr which will give us short exposure when the WTI near month contract prices near the 50 day sma at $77.

The European Confidence report and the Chinese Industrial Purchase Managers survey have added to uninspiring anecdotes concerning bond market weakness in the U.S., Europe, and China, to reassure us of our bearish positions here.

Some readers will like none of these strategies, while others will find them all interesting at these levels. Remember to do your own research and by all means tell us why we are RIGHT or WRONG in the comment box below!

Where We’ve Been

1.) The iShares Dow Jones US Financial Sector Index (DJUSFI) ETF (IYF) has rallied 34% in the last 52 weeks, to 51.51 on February 4, 2010.

2.) The DJUSFI itself, which IYF is designed to mimic, presently totes a 61.07 trailing p/e when accounting for earnings losses.

3.) The DJUSFI’s forward p/e appears reasonable at 13.36 when accounting for positive and negative earnings, yet the expectations of future earnings, used to compute this number, are based on a full scale U.S. economic recovery.

4.) Higher p/e ratios are tolerated as upside earnings surprises have helped to keep multiples low throughout the latter half of 2009.

Consider the possibility that your view is now the byproduct of a positive feedback loop, fueled by a bias that is based on a string of positive surprises. Statistics reminds us to rely only on pertinent, non random, past data when forming hypotheses and to discard random events, disguised as oracles.

Signal Flares

Looking ahead, we see a trend forming in the very sector which plagued the economy into recession. New home sales have fallen to 342,000 units in December (just above the March 2009 low) after the initial housing stimulus expired and a new incentive package failed to pick up the slack. Simultaneously the Case-Shiller resold home price index stalled in October and November and existing home sales in December tanked to the lowest level since August. Most disconcerting was the jump in months supply of existing homes which jumped almost a full month to 7.2 months worth of housing inventory.

Where the Money Came From

Banks have profited from three factors in the latter three quarters of 2009 that could actually hurt them in 2010. (1) It’s no secret that the Federal Reserve propped up the nations largest banks through the largest liquidity campaign in the history. Mortgages are still being purchased by the Fed, but they have vowed to quit the purchases of MBS from Fannie and Freddie by the end of March. These purchases allowed potential buyers of similar assets on private balance sheets to find a market price and risk taking re-entered the market. (2) Once it was clear that banks weren’t going to fail or be nationalized the first leg of the rally carried prices from book values near .50 to levels nearer to fair value. At this point , it was still understood that the “infected” TARP banks would need some wiggle room to begin lending and get their capital requirements up to par. The answer was found in the repealing of “mark to market” accounting (FASB 157), where banks were suddenly able to keep Real Estate Owned (REO) properties, which had been foreclosed and seized by the bank, on their balance sheet at a price estimated by the bank itself. (3) The rally, which resulted from the new found faith in the financial system as a whole, carried confidence and thus risky investments into the market. This return to risk naturally benefited banks through increased fees and expenses from their brokerage arms and increased profits from proprietary trading of their own funds.

Holes in the Cheese

Just as these three factors contributed to the investment in banks in 2009, we see most bank shares at artificially high prices, supported by unsustainable multiples, and several reasons to doubt the foundations of U.S. banks. The 10-year Treasury rate and the 30 year fixed mortgage rate are at historic lows amidst a record U.S. fiscal deficit of 1.4 trillion USD in 2009, insisting that the end game will include higher rates on mortgages in the future. Taking it one step further, we see recent strength in the USD index, and an upward trend in the 10 year Treasury Note yield, forcing borrowing costs to rise in 2010 and decreasing the incentives for home owners to buy and traders to trade risky assets. This shift will be doubly negative for banks as rates chip away new found cash flows from mortgage refinances and profits from proprietary trading. Similarly, higher rates in 2010 will force 2009 refinanced payments higher, where ARM’s reset at rates above “teasers”, and fixed products will become less attractive to new buyers on the margin. The benchmark Treasury Yield (10 year note) illustrates the bottoming of the yield below.

How to Play It

If you look through our archives you’ll see that we held a position in the ProShares Double Short Financials ETF (SKF) earlier in 2009. SKF follows the 2x inverse of the DJUSFI and has been on a wild ride over the past two years. I will be the first to tell you that we did very poorly by holding this position, as our assumption that (a) market handicappers would overstep the obvious but short term increases in profits due to the revision of accounting rules (FASB 147) and (b) that trading fees and proprietary trading gains would be short lived for financial firms, as the market topped and returned to a decline in mid summer 2009. You should know that this did not occur and we ended up closing the position in August for a considerable loss.

While we did take a loss, we see SKF as a crucial element to our financial strategy in 2010. We are bearish on blue chip financial firms in 2010, due to the ramifications of rising interest rates, widespread exposure to mortgage defaults, and a tired equity market. However, it is prudent to hedge where value lies, and in financials we found our protection in the obvious favorite.

We are playing the financial volatility with expectations for weakness, by going long Goldman Sachs (GS) and 2x short the Dow Jones U.S. Financials Index, using an equally weighted long position in SKF. Review the charts below of both names. GS is actually included in the DJUSFI, as the fifth largest holding, yet it’s 7.1 p/e and 1.39 price/book make the firm an incredible value, compared to it’s DJUSFI peers.

-GS 6 month performance-

-SKF 6 month performance-

By opening positions in both GS and SKF, with an equal share of capital in each, we are playing a sort of bear biased saddle. While we expect financials to fare badly in 2010, GS has relatively little exposure to mortgage issues and has proved that it’s innovation will prevail in any environment. The firm has missed earnings estimates only three times since Q2 of 2001, and has exhibited solid dividend yield and earnings per share growth over a 10 year period. By trading this strategy on a weekly basis, we will sell shares and capture gains from the winning position and add this capital to the other vehicle. Should our thesis prove correct, we expect that losses from goldman sachs will be limited, and that their value relative to the financial sector will support share prices in most environments this year.

Remember this is an active trading strategy and unknown market factors can always drastically change prices over short periods of time. For added protection enable loss stops on both positions to protect yourself from extensive losses.

Disclosure: Long GS, Long SKF

Combine the absence of economic indicating data on Friday and a hand full of releases spanning Tuesday to Thursday, and the spotlight turns squarely on the weeks earnings reports listed by day below…

Tuesday: Citigroup (C), CSX Corp. (CSX), McMoRan Exploration Co. (MMR)

Wednesday: Bank of America (BAC), Ebay (EBAY), Logitech International (LOGI), Morgan Stanley (MS), Starbucks (SBUX), U.S. Bancorp. (USB), Wells Fargo & Company (WFC)

Thursday: American Express (AXP), Burlington Northern Santa Fe (BNI), Capital One Financial (COF), Fifth Third Bancorp (FITB), Freeport-McMoRan Copper & Gold (FCX), Goldman Sachs (GS), Google (GOOG), Southwest Airlines (LUV), Union Pacific (UNP), Xerox (XRX)

Friday: BB&T (BBT), General Electric (GE), McDonalds's (MCD), Schlumberger (SLB), Suntrust (STI)

Tuesday 

The late trading week will start in a hurry Tuesday morning as C and MMR are scheduled to announce earnings before the market open. Citigroup has been plagued by sub par lending standards and may miss the expected -0.33 EPS due to higher defaults and weaker Commercial Real Estate fundamentals, cited in JP Morgan's results on Friday. MacMoRan will likely have benefited from higher oil prices over the quarter, perhaps beating the -0.26 EPS consensus, yet the forward momentum for drilling and exploration of crude oil could be dampened by the recently wavering price of the commodity. The Treasury's International Capital report will hit wires at 9:00 AM, and should give some clarity to the Treasury market that has moved inversely with equities as investors seek safety and speculators look to capitalize on future supply-demand gaps of the U.S. debt. At 1:00 PM home builders' sentiment will be judged by the results of January's Housing Market Index, which weakened from 17 to 16 in the previous month. Following the close, rail carrier CSX Corp. will announce earnings, where the estimated result stands at -0.76 EPS. 

Wednesday 

The usual weekly suspects MBA Mortgage Applications (7:00 AM), ICSC Goldman Store Sales (7:45 AM), and Redbook Sales (8:55 AM), may be overshadowed by financial earnings this Wednesday. Wells Fargo (WFC) (-0.02 EPS est.) and Morgan Stanley (MS) (0.36 EPS est.) will announce Q4 results at 8:00 AM, U.S. Bancorp (USB) (0.29 EPS est.) will release numbers before the open, and Bank of America (BAC) (-0.52 EPS est.) will keep traders guessing, but vow to show their grades by day's end. While BAC and WFC expect losses, USB has the most to lose if results miss the optimistic estimates. In a quarter where JP Morgan announced an additional $2 billion of loan loss provisions for 2010 Q1 and Q2, The financial sector may reveal some skeletons. US Bancorp. doesn't have the trading arm to profit from market movement fees like BAC, MS or JPM and share a closer fate to their loan portfolio. The PPI and Housing Starts data will cross tickers at 8:30 AM, and are expected to show virtually no change in either statistic, suggesting that any big moves from these reports will impact markets. Consumer names EBAY (0.40 EPS est.), LOGI (0.27 EPS est.) and SBUX (0.27 EPS est.) will announce and be judged in after hours trading; begging attention to after-market consumer goods, communication tech spending, and consumer discretionary outlays, respectively. 

Thursday 

While Jobless Claims will demand an audience at 8:30 AM, following an unexpected 11,000 jump in initial claims to 444,000 last week, earnings reports will steal the pre-market show. First by Fifth Third Bancorp (FITB) (-0.31 EPS est.) at 6:00 AM, second with Xerox (XRX) (0.22 EPS est.) at 7:00 AM, and accompanied by Goldman Sachs (GS) (5.19 EPS est.) and Union Pacific (UNP) (1.04 EPS est.) some time before the opening bell. FITB will add clarity to consumer lending and commercial real estate, XRX will mirror businesses investment, GS will tell how well the best traders on the planet fared, and UNP will keep tabs on the manufacturing sector's recovery via transportation of goods. 

The Leading Indicators report, due at 10:00 AM, is expected to ease from the 0.9% November growth to 0.7% growth in December but may be weakened by recent negative surprises from labor and spending in the tail end of 2009. Simultaneously the Philadelphia Fed will release their survey of economic conditions within their respective district, which is also expected to show decelerating growth as the indicator drops from the previous high of 20.4 in December, to 18.0 in January. The EIA Petroleum Status report has been pushed from Wednesday to Thursday this week, and will be closely watched for total supply changes (currently 330 million barrels) as well as distillate stock draws and refinery capacity rates.

Reporting after the close are Burlington Northern Santa Fe (BNI) (1.22 EPS) at 4:00 PM and Capital One Financial (COF) (0.45 EPS est.) at 4:05 PM, while American Express (AXP) (0.55 EPS est.) and Google (GOOG) (6.43 EPS est.) will release earnings sometime after the bell. BNI will be an interesting post-close story to compare to UNP as traders look for moves in the transport sector, just before Capital One walks investors through an average U.S. credit portfolio. Amex will unveil the strength of their high end consumer credit book and small business arm, while Google will most definitely stomp estimates, as on-line advertising continues to gain traction. Finally, Southwest Airlines (LUV) (0.06 EPS est.) will announce results at an unknown time; a testament to consumers' marginal propensity to fly rather than drive.

Friday

On a day where there is literally no economic data to be released, Friday's market action will be acutely focused on earnings. Before the market open BB&T (BBT) (0.21 EPS est.), General Electric (GE) (0.27 EPS est.), McDonald's (MCD) (1.02 EPS est.), and SunTrust (STI) (-0.69 EPS est) will make highlights. Most of the banking sector will have reported at this stage, however results from BB&T and SunTrust will reflect loan quality and economic activity in the South Eastern states where these banks have a dominant presence. Similarly, GE and MCD will boast or bleed by changes in consumer demand for household appliances and premium priced meals at fast food restaurants. Capping off the list of noteworthy market moving events, Schlumberger (SLB) (0.63 EPS est.) will announce their Q4 2009 earnings as the only scheduled release on Friday, while it happens to be the earliest at 6:00 AM. The strength of the offshore oil explorer and driller will be influenced by spiking crude prices throughout the quarter, yet expectations for the price/barrel moving forward could have a greater effect on the stock than the corporate track record. 

Keep a close eye on earnings and economic data in this short yet furious week of market moving events. Oil is moving lower and the MACD is showing a bearish cross, leading us to make a high conviction call in our next piece that you won't want to miss. 

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Thank you and as always… Happy Trading