MINNEAPOLIS (Stockpickr) -- Oh, how quickly investors forget! While it might have worked for some to ignore an absolute-return strategy as stock values have gone up over the past two years, it's certainly clear now the value of pair trades to any portfolio. The current market environment is screaming for investors to devote some -- if not all - of their portfolios to absolute returns.
The gains of the past couple of years have proven to be unsustainable. Just when you thought it was safe to enter the market, boom!, there comes another sharp move downward. Frighteningly, this selloff has come mostly out of the blue. Sure, the doom-and-gloom crowd will tell you that a crash was coming, but the majority opinion this summer was that stocks would continue their ascent thanks to strong earnings and a growing global economy.
Fear of a global financial crisis stemming from debt issues in Europe destroyed the dream of higher stock prices. The winners in the current environment have been investors in gold and short-sellers in stocks. Absolute-return investors using a long/short approach to the market have also done well.
have fared as expected. The two pair trades of
on the long side with
( WFMI) and
on the short side are down fractionally since Aug. 5. The S&P 500 is down over 2% during the same period.
From Aug. 1, the
( ZIP) longs and
shorts netted investors a positive return of about 7%. The S&P 500 lost over 9% during the same period. Not as productive, but just as effective were the
short. The fractional loss of these trades stood strong against a market loss of about 13% for the S&P 500.
Pair trades are a powerful defense in a volatile market. Given the uncertainties around the globe investors would be wise to continue using the strategy to protect hard earned dollars in a portfolio.
Long Chevron/Short Tesoro
This oil market pair trade combination is an easy one to make. Crude oil prices have mirrored the volatility of the stock market. As crude dipped below $80, investors were selling oil stocks hard. Some oil names have been hit worse than others.
Specifically, the oil refiners react quite badly to oil price volatility. Margins in that industry require some amount of stability with crude prices. If prices are swinging wildly it is more difficult to deliver consistent and growing profits. During the recent decline in crude prices, shares of Tesoro Petroleum fell 20% from the close on July 26, including a big 8% gain on Thursday.
Integrated oil companies are likely to absorb fluctuating prices given a more diversified business. It too will be hurt by falling oil prices, but not as much as a refinery-only business. During the same period when
lost only 12.5%. That is a wonderful contrast that absolute return investors can exploit with a pair trade.
Sure, in a rising oil price environment, Tesoro is likely to recover that lost value in short order and Chevron would then lag, but that argument fails to take into account the impact of volatility. Where a pair trade might get hurt is when oil prices are stable and refiners are better able to make profits.
In this environment nothing is certain, but I do think volatility is a given. That makes a long of Chevron and short of Tesoro a solid pair trade that investors can execute in order to protect a portfolio from losses.
Long CSX/Short Frontline
Transportation stocks were pummeled during the market correction of the past two weeks. With speculation squarely on a
, investors sold anything transport-related given an expectation of slower economic activity. Why a double-dip would excessively hurt companies in that space disproportionately to other sectors is a mystery I have yet to solve.
The theory, of course, is that a slower economy brings movement of goods to a halt -- or at least brings a reduction in profits. The problem with the theory is that certain shippers, particularly the rails, should be able to better withstand a recession than say an oil shipper.
That dynamic can be played nicely with a pair trade of a rail long vs. an oil shipper short. The two I have selected here are
on the long side and
on the short side. Shares of CSX were down about 10% since the close on July 25. Frontline shares collapsed a whopping 32% over the same period. I don't think Frontline recovers.
The global financial world is changing. Without going into too much detail, I expect countries to turn more inward with respect to job creation, debt reduction and usage of commodities. As many in the oil industry have stated, the U.S.'s reliance on Middle East oil brings all sorts of problems. It would be far more beneficial to increase production at home - to take things even further, to rip apart crude dominance in exchange for domestically plentiful natural gas.
A reduction in oil being shipped would be very detrimental to Frontline. To the extent that more goods and services travel domestically, such traffic would benefit the rail companies, including CSX. This sort of story is long term in nature and involves a change in the current paradigm. With the current shock to the system, the introduction to this story is just beginning to unfold.
In my opinion, the biggest problem we face is China's artificially produced export surplus. Slowing down that runaway train would also hurt ocean shippers over the long haul. If this crisis helps solve the currency riddle in China, Frontline may be permanently damaged.
I would be long CSX and short Frontline in a pair trade to protect your portfolio.
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-- Written by Jamie Dlugosch in Minneapolis.
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At the time of publication, author had no positions in stocks mentioned.
Dlugosch is the editor of Penny Stock Winners. He has over 20 years of experience in financial markets including investment banking, equity analysis and research and money management. In addition to being the Editor of Penny Stock Winners, he is also a Contributing Editor of InvestorPlace.com and founder and editor of The Rational Investor.