At a time when markets are constantly threatened by a sudden and potentially severe correction, it is very important for investors to properly manage risk. The market could continue its run, which it has enjoyed for the bulk of the past two years, especially since this past September. But as the market teeters on the edge of a steep run-up, now is a better time than ever for investors to protect their investments by diversifying, buying option protection, and/or shorting a few stocks to take advantage of a market pullback.
At Chart Prophet Capital, one of our favorite ways to invest and still keep our money protected is through “pair trading.” Pair trading generally involves a long/short investment combination in two companies, countries, stocks, ETFs, or themes that are fairly correlated with each other, but which could offer investment gains as one stock rises and the other falls. In other words, a pair trade involves buying a stock with upside potential, and selling (or shorting) a stock that is expected to underperform. And the pair trade is usually comprised of two related stocks – in a similar sector, similar theme, or similar market niche.
By buying one stock and shorting a weaker second stock, pair trading not only acts as protection in case of a market pullback, but also allows for gains on both sides (if the long position gains, and the short position falls). Pair trading is therefore a great way to manage risk and increase investment gains while still offering the opportunity to buy the stocks you truly believe in.
Below are 10 pair trades for 2011.
Long Vietnam (VNM), Short China (FXI). After a tremendous run and massive investor interest in the emerging markets, runaway inflation and weaker market performance are beginning to show up in Asia. China, undoubtedly one of the fastest growing and now one of the major world powers, is seeing increasing signs of a housing bubble and economic growth that may begin to spin out of control. After raising its reserve requirements for certain commodities and beginning to show signs of tightening monetary policy, China may be setting up for a considerable correction as it prepares for what could be a “hard landing.” In the case that China continues to struggle, we can expect investors to take profits or look elsewhere for new opportunities as the hot China story begins to cool.
Though we are more bearish on emerging markets right now, we think a long position in Vietnam (VNM) could outperform a short position in China (FXI) because: (1) Vietnam has a very young population for continued growth, (2) if China suffers, Vietnam will suffer less because of less headline risk and less panic selling, (3) if China continues to do well, Vietnam will likely benefit from increased investor interest in other Asian countries (4) the technicals and charts look much better for Vietnam than for China.
To counter-balance a long position on Vietnam (VNM) and to take advantage of China weakness, we recommend shorting China through FXI or by buying the China Ultrashort ETF (FXP). If you think China will continue to weaken over the next few months, we’d also recommend shorting Baidu (BIDU) – the “Chinese Google” – as excitement for Chinese stocks wanes and it returns to more reasonable P/E levels.
You could also take a look at shorting the Chinese housing market through the China Real Estate ETF (TAO), shorting the Emerging Markets through a long position in the Emerging Markets Triple Bear ETF (EDZ), shorting Brazil (EWZ), or shorting South Korea (EWY) as the increased threat of potential violence or war in the region could spark a sell-off.
Long Morgan Stanley (MS), Short Goldman Sachs (GS). Though financials currently look a little weak here, after a huge run from their August lows, Morgan Stanley still looks strong after reporting good earnings this past week. Technically, Morgan Stanley’s charts look good, with a breakout move from $29 to $30 on high volume; keep your eyes on $27 and $29 as support.
On the other side of the trade, we think shorting Goldman Sachs will offer a good pair. Not only is there strong resistance at the $170 and $175 levels, but the $180-185 range is where Goldman was trading before it took a huge tumble down to below $130 starting in April (due to its legal issues).
These overhead levels provide a lot of selling pressure as Goldman’s stock price approaches; we can therefore sell GS here and rely on those levels to hold. If price action wasn’t enough, we’d also point out that their earnings were disappointing to many people this past week – they didn’t impress in the fashion that Goldman is supposed to impress; and since expectations have a huge impact on stock price, we think Goldman may be setting up for some disappointment. We also don’t like Goldman’s involvement in the Facebook story – their shady dealings in trying to manipulate the private company laws and in selling very risky Facebook shares to their investors could put them in a similar troubling legal position they found themselves in this past year. Please see “Betting Against Facebook” for a more in-depth look at the risks involved in a Facebook investment.
Along with MS, we’d recommend a look at ETrade (ETFC) or Blackstone (BX) as longs. And as a substitute for a short position in Goldman (GS), we recommend looking at Bank of America (BAC) – which has a lot of overhead issues remaining, especially with their housing exposure – or a short position on the broader financial sector through the XLF, SKF, or FAZ.
Long Oil (OIL) and Energy, Short Gold (GLD) and Precious Metals. As I’ve written numerous times (see “3 Ways to Play the Bursting Gold and Silver Bubble” and “Gold Bubble: Final Warning?”), I think gold and precious metals could be setting up for a big correction. If that is that case, shorting gold through the more popular gold ETF (GLD) could turn out to be very profitable – especially if gold is, in fact, in a bubble. There are plenty reasons to short gold here (the bulk of which I have already discussed in my articles) ranging from over-speculation to very dangerous chart patterns.
But in case shorting gold outright is too risky, we recommend betting on the energy space, and oil (OIL) in particular, to protect the gold short. If gold and commodities continue to run up in price, we could expect oil – which is a commodity as well – to gain too. And considering the fact that oil has a lot more industrial and personal use than many of the precious metals, as well as the facts that oil is non-renewable and oil consumption is only going to increase as emerging countries ramp up their energy demand, a bet on OIL could be a great pair trade to hedge a short gold (GLD) position. And though we do think oil and the energy sector (XLE) look a little toppy here, we still think oil will outperform gold in the future.
As for other potential shorts in the gold and precious metals space, we recommend shorts in the gold miners ETF (GDX) or through individual miners such as Barrick Gold (ABX), Newmont Mining (NEM), or Goldcorp (GG). We also recommend potential shorts of Silver (SLV), Rare Earth Elements (REE), Molycorp (MCP), North American Palladium (PAL), the Physical Palladium ETF (PALL), or our favorite gold and copper short – Freeport McMoran (FCX). [Please keep in mind that shorting stocks with such tremendous momentum could put you at risk of big losses. If you do decide to short any of these names, please establish firm exit points before investing or short these names with limited monetary risk through put options.]
Other recommendations for long pair positions include Natural Gas (GAZ), diamond plays like Zales (ZLC) or Blue Nile (NILE) – [See “Forget Gold, Buy Diamonds”], Exxon Mobile (XOM) – which has its hand in everything from oil to natural gas to helium, or the solar energy space – through companies like JASO and LDK, or through the solar ETF (TAN).
Long Natural Gas (GAZ), Short BP (BP). Though oil has been in a very strong uptrend along with the rest of the commodities, it may still underperform natural gas – which stands to benefit from the very high oil prices. As high oil prices begin to take their toll on company balance sheets and consumer bank accounts, natural gas may gain in popularity and cease its fairly long-standing position as weakest energy play. We believe natural gas (GAZ) will either outperform oil if oil continues to rise (as it catches up to oil’s price moves), or will outperform oil as oil falls (due to oil’s bigger drop from current levels).
Our favorite way to short the oil space is currently through BP (BP) – with overhead resistance at $50 and plenty of legal and logistical headwinds because of its recent and traumatic oil spill, we think shorting BP here is a very good pair trade with a long bet on natural gas (GAZ).
Long Potash (POT), Short Caterpillar (CAT). Though we’re not too bullish on the agriculture or commodity space, we think Potash (POT) and other agriculture plays will outperform Caterpillar (CAT) in the next few months. With CAT up almost 400 percent in two years, especially considering it’s a Dow stock (which usually don’t see such tremendous price gains), we think it’s due for a correction.
Moreover, CAT’s growth depends on continued global growth – which could be severely limited if China continues to struggle. And while Potash has seen a massive run as well – with buyout speculation and the explosive ag space – it has more upside potential if the market and soft commodities continue to run. Other commodity plays to take note of are Sugar (SGG), Corn (CORN), Cotton (BAL), Coffee (JO), and the Agriculture ETF (DBA). We would currently not recommend any positions in these other plays, but their performance over the next few days or weeks could tell us a lot about where commodity prices are headed.
Long Dean Foods (DF), Short Chipotle (CMG). After a 500 percent run in less than two years, Chipotle may have peaked. For that reason, we recommend a short position in CMG with a stop-loss if price exceeds $240 (it is currently at 223.63). Since it has run up so forcefully, it could be setting up for a hard fall.
On the long side of this pair trade, we’d recommend Dean Foods (DF). Besides for the fact that it is heavily touted by hedge funds recently, we also like it because it was one of the worst-performing and most beaten-up stocks of 2010. It is nearing overhead resistance, but it looks like it has enough upside momentum to outperform Chipotle.
Long Hovnanian (HOV), Short Homebuilders (XHB). As the housing market oscillates between recovery and double-dip, we’re left wondering whether now is the right time to buy housing stocks. And though many of the homebuilders have seen a nice run recently, there is a lot more left on the upside if the market continues to climb. Technically, we think the homebuilders are due at least for a minor correction; but we remain strong believers in the homebuilders if the market is to recover well.
Our favorite homebuilder has been Hovnanian (HOV) for quite a while now – with a short interest of over 33 percent and with its recent acquisition of lots of new plots of land, we think HOV will benefit a lot from a housing recovery and a potential short squeeze – especially if the price climbs above $5 and becomes available for mutual funds. On the other hand, we think the homebuilders as a whole (XHB) are due for a correction at least in the short-term. A short of XHB will therefore help offset some of the losses if HOV slides. But if the housing market recovers, we expect HOV to highly outperform the broader homebuilder sector.
Long Hewlett-Packard (HPQ), Short Baidu (BIDU). Though much of the Tech sector looks overbought at these levels, HPQ still looks pretty good – especially with its new management and respectable recovery from its August 2010 lows. On the other hand, Baidu (BIDU) is set up for a fall if China continues to weaken – and especially because it’s seen such a huge run in the past few years and has a trailing PE of 86.5.
Many of the technology stocks make good shorts at these levels. We think the recent weakness in Apple (AAPL) – with Jobs’ health issues, increased competition, and terrible price action, make AAPL a decent short with a stop-loss at 350 [See “11 Reasons Apple Could Fall in 2011”]. We also think the tremendous weakness in the cloud computing space make companies like Salesforce (CRM), F5 Networks (FFIV), Rackspace (RAX), and the broader technology sector (XLK) very risky at these levels [See “Cloud 9 Computing: Signs of a Renewed Technology Bubble?"]. Though we wouldn’t recommend shorting FFIV before at least a small pullback to recent highs, CRM and XLK may be good short trades to pair with a long position in HPQ or Microsoft (MSFT).
Long Kodak (EK), Short Netflix (NFLX). After a 400+ percent increase in less than one year, Netflix has begun showing considerable weakness: the CFO left suddenly to pursue other interests, insider selling has been at tremendous levels for months (we’d expect low insider selling if the company’s executive officers actually believed in the future price appreciation), the Netflix business model is showing signs of faulty strategy [see Whitney Tilson’s recent article “Why We’re Short Netflix”], and the charts are showing a potential reversal pattern leading up to Netflix’s earnings release.
On the other hand, we really like the Kodak (EK) recovery story. After revolutionizing photography, film, and numerous other media-related products and services, Kodak almost slipped into obscurity. Their business wasn’t able to adjust to the rapid change in technology, and they were almost written off completely. And while we aren’t betting on Kodak to return to its previous heights, we do think it offers a great investment opportunity as it recovers from the deepest trenches, makes a very good buyout candidate, and is set up for a massive short-squeeze with over 24 percent short-interest.
Long Biotechnology (IBB), Short Retail (XRT). After a tremendous recovery in retail stocks, we think it’s time to short the retailers. The holiday and shopping season turned out great for the retailers, but we think much of the good news is already factored in. We therefore recommend a short position in XRT for the retail sector as a whole, or a short position in CROX – which we have been in for a few weeks now. After such a run, it’s time for retailers to take a bit of a breather.
On the other side of consumer “health,” we think advances in biotechnology and revolutionary drugs make the biotech sector (IBB) a good long position to pair with a retail short. And though the biotech sector has seen a run of its own, we think it will outperform retail from here. Individual names we like in the biotech sector include Arena Pharma (ARNA), Affymax (AFFY), Cephalon (CEPH), Momenta Pharma (MNTA), and Arqule (ARQL) – but these volatile and relatively smaller-cap stocks should be invested in with extreme caution.
We are still very cautious about 2011, as there are many headwinds and potential risks that could derail our economic recovery. Keeping the risks in mind, however, and pairing our favorite trades with certain picks we believe will underperform, allows us to hedge our positions while still taking advantage of both the ups and downs in the market.
Additional disclosure: We are also long FXP, EDZ, POT, NILE, JASO, EK. We may initiate positions in any of the above mentioned stocks or ETFs through stocks or options plays.