Canaries

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The chart above is a chart of MTL. We were in and out of it when it was trading within its channel, but sold it when it broke through the bottom of its channel and simultaneously took out its 100dma. Now that its 100dma is starting to slope down, we have a stock that is trading below its downtrending moving average... the very definition of a downtrend. This stock will continue going lower until it hits $0, or unexpected industry-specific news turns it around.

It doesn't look good for MTL. This doesn't mean it won't have relief rallies along the way. It just means that it is now in a downtrend, and there is no reason to think it will perform any better than CROX or BCSI for the forseeable future.

This brings us to a more important issue... fertilizer. There are many signs of weakness in the commodities market. MTL is a steel company, and we see weakness there. OIL is a commodity and there is an obvious recent downturn there (break of trend channel, break of moving average). It has always bothered us that the fertilizer stocks trade like commodities. We much prefer the days of buying and selling DELL, AOL, AMZN and GOOG, where at least the number of variables affecting the stock's price was manageable. With these fertilizer stocks, we feel somewhat at the mercy of an uncontrollable commodities market.

So how is this post about canaries? Back in the day (before carbon monoxide detectors), miners would bring canaries in cages into the coalmines. The small birds were sensitive to even trace amounts of deadly gases, and would quickly die if exposed to them. If the birds died, the miners knew that they themselves should exit the mine. We use this analogy to describe stocks because there are strong stocks (the miners), and weak stocks (the canaries), in the same sector. When you start to see the weaker stocks break down, you know it's time to sell the stronger stocks because it won't be long before they succomb to the weakness.

Right now, with commodities breaking down, we are being given early warning about the fertilizer names. This is why you want to stick with best of breed, and always buy low. Investors in MON (a weak fertilizer stock), are more vulnerable than investors in POT (a strong fertilizer stock). MON is breaking down more and more each day. It has already broken the bottom of its channel and its moving average. It is our canary in the coalmine.

So does this mean the fertilizer trade is dead? It may be on the brink of complete failure, but we're sticking with it. Here's why...

First, not all of the fertilizer stocks have broken down. POT, CF and AGU remain strong. MOS is weak, but is staying within its channel nonetheless.

Second, the fertilizer stocks report earnings next week. This is a big shot in the arm for them. It's what pulled them out of their slump in early April.

Third, this market is rotational. The money has moved out of commodities and into financials and homebuilders for now, but that will come full circle at some point. Citigroup has rallied from $14 to $20 over the past 3 days. Would you buy it here? At some point, the rotation will draw money from the financial names and it will be looking for somewhere to go. When money needs somewhere to go, it usually finds it way into the familiar rather than uncharted waters. This psychology is what creates overall trends in the first place.

Fourth, the valuations of these stocks are very reasonable. We understand why an Amazon or a Yahoo at a p/e of 120 finally reaches a point where its valuation outstrips its earnings potential. But in fertilizer, we have p/e's of 10 to 20, well within standard range for the S&P500.

Fifth, it is often a confluence of events that triggers a large move in a stock's price, with a single event acting as the sole catalyst to spark the move. With the fertilizers, we have extremely popular, strong stocks with stellar earnings that have just corrected significantly. All they need is a catalyst. Next week's earnings are the perfect excuse from which to launch a very profitable rally. This is in keeping with our theory that beaten up stocks respond positively to earnings reports and overvalued stocks respond negatively to them, almost regardless of the contents of the reports themselves. We said we would have an opinion on how these stocks would react to earnings as they get closer to their release dates. We are definitely leaning toward a positive reaction to earnings considering how much they've dropped ahead of them. We still have a few days before earnings, but it looks like they'll remain under pressure until they are released.

So what are we doing now? We are a decisive group of traders, for better or worse. We've made the decision to stick with the fertilizer trade (despite some canaries dropping dead), until earnings are released next week. We will have a better idea about their future once we see their reaction to these reports. In the spirit of sticking with our trade, we are actually buying more into this drop. We added some MOS today at 127, bringing our total stake in fertilizers to 64% of our portfolio. The rest is currently either in cash, DDM, and SMN.

We do not recommend people follow us blindly into this trade. It is a high-risk proposition and we are particularly skilled at damage control should things go wrong. Do your own homework, and make your own investment decisions.