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Over the past five years, as the equity markets around the world have rallied back from financial crisis lows, correlations between stocks have been on the rise. Macro trends have proved more important than ever. However, with the U.S. equity markets now trading at all-time highs I believe individual stock selection will again become important. There are three reasons why one of my favorite pairs trades right now is to be short Wal-Mart (NYSE:WMT) and long Macy's (NYSE:M).

1. Valuation

As shown by the chart below, WMT and M trade at a similar PE ratio. Currently, WMT is trading at a slightly higher PE ratio than M. What is more important, in my opinion, is WMT & M valuations relative to historic norms. WMT current valuation is close to the upper limits of its historical valuation trend. This means that major upside seems highly unlikely for WMT. For a company as large and mature as WMT, it is difficult to argue that the stock should trade well above historic high valuations. Contrastingly, M has traded at significantly higher valuation than current levels. Given this, if M reports strong results in the coming quarter the stock could easily drift towards historically higher valuations close to 20 times forward earnings. Even if WMT reports strong numbers in the coming quarters, it is unlikely that the stock will experience multiple expansion due to current valuations.

M PE Ratio (Forward) Chart
(Click to enlarge)

M PE Ratio (Forward) data by YCharts

2. Management

WMT recently announced a change in leadership: CEO Mike Duke will be replaced by Doug McMillion effective February 1, 2014. McMillion will likely make some change once he takes over the CEO role. These changes will likely be long-term goal oriented and could cause some short-term growing pains. Change is never easy, especially for a company as large and complex as WMT. If the transition of executive leadership goes well, I do not expect to see WMT shares make any significant gains because they are already trading close to the upper end of historic valuations. On the other hand, if there are some short-term stumbling blocks during the executive leadership transfer I think WMT are vulnerable to the downside. In contrast to WMT's unstable management outlook, M is run by Terry Lundgren, who has proved to be a terrific leader for the company. In my view, M deserves to trade at a premium valuation due to Lundgren's strength as a manager. Comparably, I believe WMT investors should take a wait and see approach to the new CEO before deciding if WMT shares deserve a high management premium.

3. Improving Economy

M targets higher-end consumers than WMT and has higher quality offerings. As the economy continues to improve, I expect some shoppers to switch from lower-end stores such as WMT to mid tier retail shops such as M. The improving economy has the potential to help M while hurting WMT, which could lead to a significant divergence between the respective stocks. Another key factor which has the potential to help M but not WMT is the wealth effect. With real estate prices on the rise and equity markets trading at all-time highs, consumers are likely feeling a little richer. M customers are far more likely to own assets such as stocks and real estate than WMT customers. Due to this, the wealth effect is likely to have a positive impact for M but not WMT.

Risk To My View

The biggest risk to my view is that the economy takes a negative turn. While I am not convinced the economy is about to weaken anytime soon, it must be mentioned as a possibility. If the economy loses steam I would expect WMT to outperform M. However, due to WMT's high valuation I believe shares would still come under pressure in a weakening environment for equities. In short if the economy continues to improve, I believe M has significantly more upside than WMT. If the economy slows, I believe M has only slightly more downside than WMT.

Source: Time For A Pairs Trade: Short Wal-Mart, Long Macy's