This lack of clarity would lead many investors to remain on the edges and refrain from assuming risk.  However, there is great opportunity cost with such a stance.  Instead, I prefer to find stocks with a downward bias that allow me to hedge my current portfolio yet offer the comfort of a clear technical pattern.  This search brings me to MasterCard (MA).

As initially featured in my weekly newsletter (http://www.stocktradingtogo.com/2008/11/16/epic-insights-weekly-3rd-edition/), MA is a former market darling that has crashed to earth.  When most felt the credit crisis was contained, MA was seen as a place to hide.  By acting as a transaction processor, MA assumes virtually no credit risk and earns a fee each time their card is used.  If consumer spending held, their business would continue to grow.  This thought process led many momentum investors to pile into the stock and drove the price to an all-time high of $320 on June 2^nd.  Since that point, a weak market and overvaluation have combined to drop the stock to the current price of $141.40.

The drop in price has resulted in a clearly defined channel that has held for over 4 months.  Currently, the channel shows MA trading between $130-150 over the coming weeks with a downward bias that should result in a new low.  At current levels, MA is approaching the top of the channel and offers an excellent time to initiate a short position with a clear technical pattern.

While I do not like jumping on trades that have moved this far in a short period of time, MA is unique.  The fact that the channel has persisted during multiple market rallies provides comfort.  Further, a well received earnings report two weeks ago pushed the price over $170 before resuming the downtrend.  Also, this latest failed rally was the third lower high since late September (9/19 - $225, 10/14 - $174, 11/4 - $170.  Lower highs are characteristic of falling markets and lead me to think MA may retest the October 27^th low of $126.35.

Combining these observations, MA offers unique attributes in today's market.  It faces economic headwinds that will restrain business growth, trades in a clearly defined downward channel and has been showing technical weakness with a series of lower highs.  Therefore, I view it as an ideal short sale candidate.  If the general market continues lower, we profit.  If the technical pattern holds, we profit.  Given the uncertainty in this market, I welcome the opportunity to trade with clear patterns and defined fundamentals.

Related Stocks:  MA

Related Stocks:  PERY

http://www.stocktradingtogo.com/2008/11/16/epic-insights-weekly-3rd-edition/

Related Stocks:  IIJI

                While bottom fishing, we must also remember that markets can stay irrational longer than we can remain solvent.  Therefore, look to hedge your positions in the most advantageous manner you can find.  Traditionally, investors buying stocks could pay a small premium for a put option to insure against large losses.  With VIX trading above 60, option hedges have become uneconomical.  Knowing this, I look toward pair trades as a means of hedging my risk.

                The purest pair trade is one where you are long and short of two stocks in the same industry.  Doing so allows you to eliminate factors that would affect the industry and trade the relative valuation of each competitor.  I often look to be long of the stock that is either more reasonably valued or is the better operating company.  Conversely, I will short the company that is overvalued or has an inferior operating business.  Within this framework you can often find trades where one of the two criteria is met.  On rare occasions you are presented an opportunity to own the stronger company at a low valuation and be short the weaker company at a high valuation.  Today we are presented that opportunity.

                I find the trade in the airline industry.  While I acknowledge that the airline industry has large structural problems and little earnings visibility in the current economic environment, I do not want to make a statement on absolute valuation.  Instead I will focus on relative valuation and the opportunities presented.

                For the long side, I recommend buying Continental (CAL).  CAL is among the strongest of the airlines and has tended to trade at a premium valuation to its competitors.  On a trailing 4 quarter basis, CAL has lost $.3 million on sales of $15.1 billion.  Looking at their balance sheet, debt is high with total debt nearing 76 times total capital.  While the inability to earn a profit on $15 billion of sales and a large debt level would scare most away, looking at certain competitors justifies the pair trade.

                On the short side, UAL (UAUA) - more commonly known as United Airline - has lost nearly $4 billion on sales of $20.5 billion over the past four quarters.  Looking at the balance sheet, UAUA's debt is approaching 119 times total capital.  If we thought CAL's results and balance sheet were poor, UAUA's are frightening.

                Given the profitability and leverage of each airline, I could recommend shorting UAUA and buying CAL.  However, investors are offered one additional benefit.  For the past 6 months, CAL has traded at an average premium to UAUA of 158% with a median premium of 155%.  Currently the premium is 108%.  The last two times the relative valuation was this low, CAL's average premium was restored in 13 and 18 trading days, respectively.  This quick mean reversion translated into 30% gain in a few weeks time.

                This market has been unforgiving over the last two months as indiscriminate selling has altered how investors behave.  Within this chaos, opportunity exists.  Being long CAL and short UAUA allows an investor to reduce risk to the overall economic environment while being long a superior company at low relative valuations and short a weak competitor at high relative valuations.  Whether it is the economic backdrop or company specific news, I expect CAL's traditional premium to UAUA to resume and deliver quick, meaningful profits to opportunistic investors.

Related Stocks:  CAL, UAUA

Personally, I have watched this market with the belief that we have overshot to the downside and normal technical factors would work prices higher.  For a few days that theory worked.  The Dow Jones Industrial Average (Dow) hit a closing low of 8,175 on October 27^th.  From there the markets worked higher with the Dow closing at 9,625 on November 4^th (18% in 6 days).  Since that day, we have spiraled lower with the Dow threatening to retest the October low.

Such violent action makes predicting the next move difficult.  A violation of the October low would have severe repercussions as support levels are violated and the market spirals to unknown levels.  However a resumption of the uptrend that pushed toward Dow 10,000 would incite bullish actions and could result in a surprisingly strong market rally.  While some investors will sit on the sidelines and wait to see which price point falls first, doing so has enormous opportunity cost.  Properly trading the rally or decline can make a large difference in your portfolio performance.  Therefore, I prefer to analyze the internal market actions and best assess where the next move will take us.

Looking at the Dow, I will focus upon price change, daily volatility and volume.  Further, I have broken the market actions into three main time periods.  These periods are September 2^nd - 30^th (when a down year turned ugly), October 1^st - 27^th (when the bear market spiraled lower in relentless fashion) and October 28^th - November 10^th (the period when the Dow has moved toward a retest of the prior lows).

Entering September, the Dow was down 13% for the year.  Most investors were displeased with the market's performance, but had not turned despondent.  During September we saw the failure of LEH, various financial rescue plans and a bad market turn worse.  By the end of the month, the Dow was 18% lower for the year and had officially entered bear market territory.  During the month, the Dow finished lower 11 trading days and higher 11 trading days.  However, down days saw declines of -2.62% on average volume of 6.1 billion shares and up days saw average gains of 1.9% on volume of 7 billion shares.  Although the market had dropped 6% on the month and daily volatility (measured as the difference between the high and low price on a given day) averaged 4.2%, there was reason for optimism.  During the month, large declines were followed by sharp rallies and the internals of the market showed volume higher on up days than down days.  Unprecedented fiscal and monetary stimulus had been applied and the belief was policymakers would do all in their power to keep the economy from traveling into the abyss.  Those thoughts were premature.

During the 19 trading days between October 1^st-27^th the bottom fell out.  Over those 19 days, the Dow finished lower 15 times with the average drop being 3.25% on volume of 7.2 billion.  While the 4 positive days staged rallies of 5.6% on volume of 6.9 billion shares, the overwhelming negativity damaged investors' portfolios and psyches.  Daily volatility skyrocketed with the VIX reaching all time highs and the daily price swing in the Dow averaging 7.9%.  On 5 days, the average price swing exceeded 10%.  We have all heard how long term stock returns average near 10%.  A lucky trader who was short at the high of the day and closed his position at the low had 5 chances to make one year's gain within a few hours.

The internals of these 19 trading day show a market being crushed by the bears.  With relentless drops in the Dow, volume was higher on down days and volatility spiked.  While the Dow staged an occasional rally, the gains were infrequent and could not stop the downtrend.  During this period my timing model was 100% (an unheard of oversold signal) and required a 55% rally in the average stock for the model to reach a more neutral reading.  Looking at these statistics, one could expect the capitulation phase was reached and that markets had bottomed.

Calling a bottom and trading long since October 27^th looked brilliant for a week, but now raises questions.  Was the 18% rally a bear trap or is the current retest what is needed to reaffirm that we have hit bottom?  Turning to the internals, I am hopeful that the current move is a retest of the lows that will set the stage for a sustained move higher.  Over the past 10 trading days we see the market finishing higher 5 times and lower 5 times.  On the up days, the market has moved 4.2% higher on average volume of 6 billion shares.  For down days, the market has fallen 2.3% per day on volume of 5.5 billion shares.  During this period, daily price swings have dropped to 5%.  The ability to move higher on rising volume, go lower on shrinking volume and see volatility decrease are all bullish events.  Therefore, I see the current sell-off as a retest of the prior lows.  If those lows hold, we should begin moving higher in a fashion that sets the stage for a powerful market rally.

From an investment perspective, how should one use this information?  Carefully.  I am currently long of the market and expect to maintain my positions.  I will be using the volatility to indentify trading targets, but am shying away from committing large amounts of capital.  As the Dow falls toward the October lows, short weak stocks and buy those that are strong.  Doing so will allow you to balance risk while realizing gains.  If we test the lows and move higher, skew the portfolio long for a quick rally.  Given the speed with which this market moves, it is important to be nimble, effectively manage risk and always look for the next trading target.

http://www.stocktradingtogo.com/wp-content/uploads/2008/11/epic-insights-2nd-edition.pdf

Related Stocks:  NOV

1. The Week Ahead - Identify key economic reports, earning's releases, and other events that could lead to swings in stock prices.
2. Technical Trades - Trade ideas via technical analysis.
3. Fundamental Trades - Trade ideas via fundamental analysis.
4. Option Trades - Trade ideas through options.
5. General Comments - Sean and his team share their general market thoughts.
6. Current Recommendations - Track Sean's recommendations to see how they would perform each week in a live portfolio.

I designed the newsletter to be beneficial for any investors regardless of experience. It will prepare you for the week ahead and provide actionable trade ideas that all traders can use to improve their portfolio's return.  It is a fantastic read and should become a Sunday night routine for any investor wanting to stay on top of the market.

To read the letter and subscribe to the email distribution, use the following link:

http://www.stocktradingtogo.com/2008/11/06/read-sean-hannons-new-financial-newsletter/

Related Stocks:  CVI, MECA

Related Stocks:  MECA