2 Commodity Pair Trades for Absolute Returns

MINNEAPOLIS (Stockpickr) -- The New Year is only a few weeks old and already certain trends are beginning to take shape. Stocks continue to move higher but with seemingly less conviction. The larger stocks are making most of the gains in 2011, while smaller stocks take a bit of a breather.

The vaunted January effect, whereby smaller company stocks outpace their larger brethren, has yet to take hold. The market appears to be waiting for evidence that profit growth can be maintained within a fragile economic framework. That alone is a major shift from the early stages of the bull market when stocks could appreciate on the mere whiff of profit growth.

Another interesting trend that is developing is in the gold market. After gold busted through $1,000 per ounce last year, many, myself included, speculated that the next stop would be $2,000. My own thesis hinged on the fact that gold was increasing in value irrespective of the economic facts of the moment.

What I mean is that gold tended to increase in value no matter the movement of the economy. If traders believed the economy was strong, gold rallied. The idea was that with a strong economy, inflation would soon follow. Gold would also increase in value when the economy appeared weak. The world-ending scenario combined with stimulus required to pump a failing economy would ultimately devalue currency triggering domestic inflation and higher gold prices.

Related: Add Commodity Exposure With These ETFs

Gold wins no matter the circumstance -- or so it seemed. But that no-lose proposition is beginning to break this year. Strength in the U.S. economy led to currency appreciation, thus muting the inflationary impact of a falling dollar.

Gold traders were more concerned about dollar strength than the longer-term risk of inflation caused by too much economic growth. The price of gold has dropped during the early trading of 2011.

A similar situation unfolded in the oil markets. There the action had more to do with technical issues and hedge fund shorting of oil as crude pushed to $100 per barrel. Big dollar traders are not convinced of economic strength and thus sold oil short in response.

The takeaway from the early-going is that the risks in the commodity markets appear to be increasing. While gold and oil may continue to rise, the previous near-guaranteed returns in those two commodities are dissipating.

With this in mind, commodity investors might want to take a more cautious approach. One of the best ways to do that is with a long/short pair trade strategy. Here are two commodity pair trades to consider.

Long Barrick Gold/Short Yamana Gold

When thinking about a pair trade, I'm thinking about defense. In the gold market there are two ways to play a long/short trade. The first would be to take a long position in actual gold using an exchange-traded fund that owns the metal. This position would be paired with a short of a company that makes its money mining gold.

Another way to accomplish long/short exposure would be to use size to your advantage. I already discussed how large stocks are off to a better start in the market than smaller ones. In the mining space, there is a dichotomy of large miners and smaller players.

Thus, the way I would execute a pair trade in the mining space would be to own long a giant mining stock and sell short a smaller mining stock. On the long side I would use Barrick Gold ( ABX). This giant gold mining company has a market capitalization of approximately $47 billion.

On the short side, I don't want to go too small, because the smaller mining stocks can be quite volatile. I'll slide down the size chain to Yamana Gold ( AUY), which has a market capitalization of approximately $9 billion.

The valuation of both of these stocks sets up nicely for a pair trade. Barrick Gold trades for 15 times 2010 earnings and 12 times forward earnings. Estimates are for Barrick to grow earnings by 25% in 2011.

For Yamana, the valuation is a bit higher. Shares trade for 21 times 2010 earnings and 13.5 times forward earnings. Analysts expect Yamana to grow earnings by 50%. On the upside, Yamana should do better than Barrick, but it likely will perform worse if gold prices fall.

Barrick Gold shows up in the portfolio of NWQ Investment Management, and Roberto Pedone highlighted it recently as a gold stock that could shine on a pullback.

Yamana shows up in the portfolio of Donald Smith at Donald Smith & Co., and according to Karvy Global, it's one of 10 metal and mining stocks that analysts favor.

Long Chevron/Short Chesapeake

In the oil market I am taking a bit of a different approach with my pair trade. I'm extending my exposure in oil to the natural gas market. Both oil and gas are closely correlated, but domestically, large supplies of natural gas are likely to keep prices stable.

Here, then, I want to be long oil and short natural gas. I'll use size to my advantage by going with a long of Chevron ( CVX). On the short side, I'll go with themuch smaller Chesapeake Energy ( CHK).

Looking at Chevron, it is no wonder investors are gravitating to larger company stocks. Chevron and its $186 billion market cap trades for 10 times 2010 earnings and nine times 2011 estimated earnings. Analysts expect the company to grow earnings by approximately 10%.

The big kicker for investors is the dividend. Chevron pays investors a dividend of just over 3%. There is upside opportunity and downside protection with a long of Chevron.

As for Chesapeake shares trade for 10 times 2010 earnings and 11 times forward earnings. Analysts expect the company to earn less in 2011 as compared to 2010. The natural gas player pays investors a dividend of approximately 1%.

The commodity markets are on shakier ground. Future direction is unclear. For investors looking for exposure to commodity markets pair trades make sense in such an uncertain environment.

Chevron comprises 2.8% of T. Boone Pickens' BP Capital portfolio. It shows up on a recent list of the 10 cheapest Dow dividend stocks for 2011, and with an A- buy rating, it's one of TheStreet Ratings' top-rated oil and gas stocks.

Pickens also owns Chesapeake, as does Carl Icahn. The stock is rated a C+ hold by TheStreet Ratings.

To see these stocks in action, check out the Commodity Pair Trades portfolio on Stockpickr.

-- Written by Jamie Dlugosch in Minneapolis.

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At the time of publication, author had no positions in stocks mentioned.

Jamie Dlugosch is a founder and contributor to
MainStreet Investor and MainStreet Accredited Investor . Formerly, he was president and CEO of Al Frank Asset Management. He has contributed editorially to The Rational Investor , The Prudent Speculator , Penny Stock Winners and InvestorPlace Media .

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