Trade This Market-Neutral Strategy In December

Includes: DIA, IYT
by: QuandaryFX

In this article, I present an uncommon trade idea that an investor can utilize to generate a return in the month of December. I have isolated a unique market event, which could potentially provide profit to the nimble investor or trader. This specific idea is a pair trade. A pair trade is a market-neutral strategy in which an investor seeks to earn a return through the simultaneous purchase of one security and the shorting of another security. This strategy allows the investor to exploit a historic or statistical relationship to generate profit.

Decades of History

A unique opportunity exists in the relationship between the Dow Jones Composite Index (NYSEARCA:DIA) and the Dow Jones Transportation Index (NYSEARCA:IYT) for the month of December. Over the past 79 years, there has been a decoupling in which one index will increase or decrease, and the other index will increase or decrease, but not as much. This decoupling has led to an investment opportunity in which investors that purchase one index while shorting the other have historically gained a consistent return. Specifically, history has shown that individuals who purchase the Dow Jones Composite Index while simultaneously shorting the Dow Jones Transportation Index stand to earn on average 1.07% in the month of December. The reliability of these returns is uncanny. In 65% of all years, this relationship holds true: by buying the Dow Jones Composite Index and shorting the Transportation Index, profit can be made. The chart below shows the returns an investor could have earned had he or she pursued this strategy over the past 79 years.

(Click to enlarge)

The strength and reliability of these returns are excellent. For a trader or investor seeking to gain alpha, he or she could have earned 84% in the past 79 years. You may note that the market has returned several hundred percent over this same time period, but it is important to understand that this trade represents a market neutral opportunity, or one which allows investors to profit regardless of market direction. For example, even if the market increases overall in the month of December, history has shown that the Transportation Index will not increase as much on a percentage basis. Likewise, even if the market falls during December, history has shown that the Transportation Index will experience greater declines. This provides a powerful opportunity for alpha, or market-beating returns since the difference in returns on a percentage basis is profit that can be captured. For example, in 2004, the Dow Jones Composite fell .66% and the Transportation Index fell 2.36% during the month of December. If a trader had purchased $1000 of the Composite and shorted $1000 worth of the Transportation Index, he or she would have lost $6.60 on the long position and gained $23.60 on the short position, resulting in a gain of $17.00 with negligible market risk exposure.

Any institution or investor who held a market index over the past 79 years has experienced great volatility throughout the decades. A trader who has pursued this strategy has earned a consistent return with very little volatility. Essentially, these added returns act as a cherry on top of a portfolio that provides additional gains for further compounding. By pursuing this type of uncorrelated strategy, an individual can generate absolute return, which can greatly enhance a portfolio's performance.

Statistical Reliability

Upon finding these results, curiosity drove to me to analyze the statistical reliability of this system. Specifically, I wanted to the see the distribution of these returns so as to understand if the system actually generates market-neutral alpha. A trading system that provides positive expectancy should be skewed toward positive returns throughout the years. The chart below shows the historical distribution of the returns of this strategy.

(Click to enlarge)

I find it very interesting that the majority of the distribution is profitable. Numerically, this means that only 35% of all results have historically been negative. Additionally, the central tendency of the distribution is higher than the normal average, which means that probabilistically speaking, you have a higher percentage chance of earning more than 1% in December, if you follow this strategy and if the current distribution is a rough guide to the future distribution of returns.

Does This Make Sense?

The intelligent investor must surely be seeking a reason for this non-random price behavior. After all, if there truly was a relationship here, wouldn't arbitrageurs have eliminated this opportunity? Well, strictly speaking, this isn't arbitrage! There is risk in the trade. The table below shows a breakdown of the typical risks that this strategy encounters.

It can clearly be seen that if this trade doesn't work out as anticipated, investors could potentially lose 1.68% or more. If the trade is correct however, investors stand to earn nearly one and a half times the average loss. These odds and expected payout are very favorable.

But what is the fundamental driver? Why is this happening? From a fundamental standpoint, it makes sense that the transports should lag during December since this is probably the month in which businesses do the least amount of traveling and industry does the least shipping. Or perhaps individuals are simply selling all non-core holdings going into the holidays. There are a myriad of reasons and explanations for this, but I believe the data speaks for itself. We do not necessary need to know the reason for every event in the market. History has shown that this anomaly is still profitable.

The Recommendation

In light of the past 79 years of history, I advocate purchasing the Dow Jones Composite Index, and shorting the Dow Jones Transportation Index on the first trading day in December. I believe this trade should be held until unraveled on the last trading day in December. History has shown that this strategy delivers alpha.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.