2 Pair Trades to Protect Your Portfolio

MINNEAPOLIS (Stockpickr) --Why does Charlie Brown always try to kick the ball? He knows darn well that Lucy will never let him touch the pigskin and yet he keeps coming back for more. Investors are very much like Charlie Brown.

Five straight days of gains will quickly erase the memory of pain and losses. Oops, not so fast. This schizophrenic market of ours will pull that football away faster than Lucy. Over the past week, stocks once again reversed course. The gods of the market decided another retest of the lows was in order.

All it took was a Federal Reserve pronouncement that the economy faced significant risks, and down we went. The Dow lost some 700 points in two days of trading. That action is not exactly a sign of stability. No amount of "twisting" by central bankers can change the fact that we are facing some serious issues here.

 Related: 5 Downgraded Stocks That Should Be Buys

As an optimist, I rarely get rattled, but I have to say the current situation is a bit disconcerting. I've seen my fair share of market and economic crisis. I am old enough to recall the pain of the oil embargo, stagflation and the decline of the rust belt. Through it all, one thing was always present: hope for the future.

Right now the country is lacking hope. Until hope returns, investors can expect markets to writhe. There will be days we go up, and there will be days we go down. Such an environment is not conducive to making profits - unless, of course, you are following an absolute return strategy.

Placing bets on the long and the short side of the market can help you navigate these hopeless trading days. A well-executed pair trade can not only protect your portfolio, but you can make money doing so.

Here are two pair trades to protect your portfolio.

Long IBM/Short Hewlett-Packard

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In a time of great uncertainty, stability is to be rewarded. In the current market environment, investors have little appetite for management teams and boards of directors that change direction at the drop of a hat. Sure, when operating profits are falling and revenues are stagnating, some amount of change is necessary, but too much change just for the sake of change is a recipe for disaster.

It should be no surprise then that news from Hewlett-Packard ( HPQ) that Meg Whitman will be the new CEO is being greeted with heavy selling by investors. Shares in early trading on Friday were down 4%. That is hardly a ringing endorsement of the move.

In some ways, the hiring reminds me of the 1990s. At that time, certain executives -- Chainsaw Al Dunlap comes to mind -- built reputations that may have been a bit overstated. Boards like that of Sunbeam, where Dunlap oversaw a massive accounting fraud, were duped by superstar power that ultimately could not be supported by true leadership.

Meg Whitman is no Al Dunlap, but I'm not impressed by her starpower. The move by HP looks like a Hail Mary to me -- and Hail Marys tend not to work. Whitman did a fine job at eBay (EBAY), but HP is a different breed. Even though shares of HP are down significantly, it is difficult to imagine shares regaining value, at least in the short term. I would short HP.

On the long side, IBM ( IBM) is the definition of stability. The company rarely makes the headlines for corporate shenanigans -- or anything else for that matter. IBM is boring, and that is a good thing for investors. Relative to the rest of the market, IBM shares have more or less hung in there during this recent bout of selling; the stock is down only 4% since the middle of July.

On an operating basis, IBM churns out quarter after quarter of strong results. Over the last four quarters, the company has bested Wall Street estimates, including a beat of 6 cents per share in the quarter ended June 30. For the full year, the average Wall Street estimate is for the company to make $13.31 per share, with that number growing 11% to $14.76 per share in the following year.

Investors can buy that stability for a very reasonable 12.5 times earnings. There is a stark contrast between HP and IBM that can be exploited in a pair trade. I would be long IBM and short HP.

HP shows up on a recent list of 3 Stocks Buffett Won't Buy at Any Price, while IBM was recently featured in " 5 Rocket Stocks to Buy."

Long Toll Brothers/Short Lennar

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Pair trading requires a different way of thinking about the market and investing in stocks. In some cases, a pair trade will involve stocks in an industry that is expected to do well. In that case, a pair trade investor may place a short trade of a stock that may increase in value.

That may be counterintuitive, but one of the goals of executing pair trades is to protect capital. In the event that analysis is proven wrong and stocks actually decline in value, that short position will offset losses on the long side. It is perfectly fine in a pair trade to short a stock that you like.

One sector that I believe is ripe for a turnaround is homebuilding. That may sound cliche -- many have made the same claim since the sector was demolished in 2008. It may also sound hollow since past predictions of a market bottom for homebuilders have failed time and time again. What is so different today?

The difference today is time and value. Homebuilder stocks have been pummeled in 2011 so much that many trade for book value or less. At the same time, we are now many years from the initial collapse. Homebuilders are no longer leveraged as they were before the collapse. Demand for new housing is building even though such demand may be masked by the vast supply of housing stock on the market.

As for a pair trade in this sector, I like Toll Brothers ( TOL) on the long side and Lennar ( LEN) on the short side. The thesis here is that the high end of the market is holding up very well irrespective of macroeconomic conditions, favoring Toll Brothers and its targeting of the luxury homebuilder. Keep in mind that I like both stocks, but in a pair trade I like Toll better than Lennar.

Both companies reported good results in their most recent operating quarters, but Toll's report was very strong. The company beat analyst estimates by 22 cents per share with a profit of 25 cents per share for the quarter ended July 31. Shares of Toll jumped above $17 in trading after the report but have since collapsed to its current price of $14 and change.

At current prices, Toll trades for 0.92 times book value. With analysts expecting the company to generate profits this year and next, losing book value is less likely. The stock deserves a higher valuation. I would be long Toll Brothers here.

On Monday Lennar reported good results as well. For the quarter ended Aug. 31, the company made a profit of 11 cents per share, a penny ahead of average Wall Street estimates. Shares got a boost from the report but ultimately succumbed to selling pressure late in the week. Lennar trades very close to its low for the year despite deliver strong results.

At current prices Lennar trades for 0.93 times book value. The average Wall Street estimate for the current fiscal year ending Nov. 30 is 53 cents per share. The expectation is for the company to grow profits by 56% in the following year to 83 cents per share.

Both Toll and Lennar are attractive from a valuation standpoint. My preference is to own the higher-margin, higher-end homebuilder vs. the higher volume, lower profit model of Lennar. In a pair trade, my expectation is that Toll will outperform Lennar on the upside with less downside risk. I would be long Toll and short Lennar.

To see these stocks in action, visit the 2 Pair Trades to Protect Your Portfolio 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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