Introducing The Income Inequality Trade

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 |  Includes: LVMHF, WMT
by: Lou Basenese

We’re living in a world of haves and have-nots. It’s the 99% versus the 1%, as the Occupy Wall Street Movement likes to put it.

While I have a hard time believing that anyone truly thinks the rich are the enemy of the poor, there’s no denying the discrepancy.

Based on the latest IRS data, the income gap between America’s top earners and bottom earners hasn’t been wider since 1928.

But I’m not here today to make a political statement. (Other than saying that America is the land of the free. And in such a society, a degree of income inequality is inevitable.)

Instead, I’m here to share an investment strategy to capitalize on the obvious trend.

Just the Facts, Ma’am

Again, I’m not going to refute that an income or overall wealth gap exists. Not when there’s so much data to confirm it.

The top 1% of Americans now own about 40% of the country’s $54 trillion in wealth. They also earn about 19% of the country’s income, up from a low of 7.7% in 1973.

Moreover, a new study by economists at UC Berkeley, the Paris School of Economics and Oxford University found that real incomes of the 1% grew 86.1% from 1993 to 2012. In contrast, real incomes of the 99% only increased 6.6% over the same period.

It’s important to note that the discrepancy is materializing irrespective of geography or political persuasion. Or as The Washington Post’s Brad Plumer notes, “The Deep South, as well as New York and California, saw the fastest growth in income inequality over time.”

So this isn’t a red or blue state thing, or an East or West Coast phenomenon. In fact, if you want to see how indiscriminate the spread of income inequality in America has been, check out this fascinating visual put together by John Voorheis, a graduate student at the University of Oregon. (As income inequality within a state increases, the color in the image changes from red to green.)

Sentiment Matters

Naturally, the difference in fortunes in America is leading to differences in sentiments between the “rich” and the “poor,” too. And nowhere is this more evident than the latest Consumer Confidence readings.

In addition to the main reading that’s widely quoted in the financial press, the Conference Board also measures confidence based on income. Sure enough, the confidence gap between Americans making more than $50,000 versus Americans making $35,000 to $50,000 has never been wider, according to Bespoke Investment Group.

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Put simply, wealthier people – as defined by the Conference Board’s income levels – feel more confident than poorer people right now. That difference is naturally going to manifest itself in spending patterns.

And therein lies the opportunity for us…

The Perfect Time for a Pairs Trade

Pardon the sweeping generalization. But it’s nevertheless true.

The have-nots patronize Wal-Mart (NYSE:WMT), the world’s largest discount retailer.

Meanwhile, the haves patronize LVMH Moet Hennessy Louis Vuitton SA (OTCPK:LVMUY), the world’s largest luxury goods company. (Its stable of high-end brands includes Moët & Chandon, Dom Pérignon, Louis Vuitton, Fendi, Donna Karan, Marc Jacobs, TAG Heuer and Bulgari.)

Reflecting the broader income trends, the sales results for the former have been much weaker than the latter. And that makes this an ideal situation for a pairs trade.

What exactly is a pairs trade? Pioneered in the 1980s by Morgan Stanley (NYSE:MS), it involves taking a long position in one stock and a short position in another. At the same time.

The way this two-stock strategy sets us up to profit is simple:

Scenario 1: The two stocks we own both go up. But the stock we’re long goes up more and faster than the stock we’re short.

Scenario 2: The two stocks we own both go down. But the stock we’re short drops faster and farther than the stock we’re long.

Scenario 3: The stock we’re long goes up and the stock we’re short goes down. The end result? Maximum profits.

In this case, we’d go long LVMH and sell short Wal-Mart.

As you can see in the chart below, doing so would have been profitable over the last year. Wal-Mart’s stock struggled to stay in positive territory. Whereas shares of LVMH are up almost 30%.

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Bottom line: Given that the income and wealth gap isn’t expected to narrow any time soon, I’m convinced this pairs trade will continue to work in the months and quarters ahead.