Every day intelligent people disagree about the direction the market. Reading the tea leaves, crunching algorithmic formulas, or simply following bottom-up fundamental analysis can convince the analyst that directional movement is imminent. When smart, well-informed analysts look a the same set of facts and come to opposite conclusions it can be quite confusing for the normal investor.
When the picture is cloudy and the investor can't decide which opposing force is right, it is useful to place a "pairs" trade. A pairs trade attempts to neutralize broad directional movement. It focuses on exploiting an inefficient pricing, between two factors that have diverged, by simultaneously buying one and selling the other. Examples would be two competitors like Coke (NYSE:KO) and Pepsi (NYSE:PEP), or two industries such as transportation and energy.
Overall Economy Led By Banking (Both Directions)
Banks are the engines that power the train. When banks are vibrant, they loan money to businesses, individuals, and governments to expand activity. If banks suffer losses, they must retrench and rebuild reserves/capital. The banks are the mechanisms through which the Fed channels the money that is created. By design, the banks must be healthy and growing in order for the money to flow properly.
A glaring issue cited by the bearish community is that the US banking system is still repairing its balance sheet and fessing up to past sins. The bears argue that without the banks increasingly lending/creating money, the economy can not go forward and will slip back into recession.
The bulls argue that most of the damage has been done, that balance sheet repair is largely behind them, and the spigots will open up soon. They remind us that the market is forward thinking, and when you actually see the growth in lending, its usually 6 months and x% too late.
Something has to give. The overall market is either overpriced and a second recession is on the way, or the banking sector's recent price weakness is a false flag and a rally is long overdue. Its either one or the other, can't have it both ways..
The Four Horsemen
Its impossible to have a real recovery without the participation of our 4 major banks; Bank of America (NYSE:BAC), JP Morgan Chase (NYSE:JPM), Wells Fargo (NYSE:WFC), and Citigroup (NYSE:C). These systemically important banks are so large and dominant, they are considered "too big to fail" ((TBTF)). Their size and reach dwarfs their lesser peers, and together they touch almost every household in America.
Divergence of 17.7%
Normally the financial sector, and particularly the large banks, have a high degree of correlation with the overall market. Sometimes there are periods of slight divergence, but the gaps are generally short-lived and shallow. We noticed a major break in this correlation since the middle of March. Specifically since March 14, 2011, the SPY is essentially flat while the [[XLF]] is down 10%. More significantly, the four horsemen are down an average of 17.7%: JPM -10%, WFC -13%, C -16%, and BAC -32%.
|March 14, 2011||July 29, 2011||Percent|
Pair Trade The Anomaly
Without worrying about whether the bulls or bears are right, you can trade this divergence and take advantage of this anomaly. Equally buy each of the 4 major banks, and then sell short an equivalent dollar amount of the SPY. The goal is to profit handsomely when this spread reverses.
The trade looks like this:
- Buy (x) $s each of BAC, WFC, JPM, and C
- Sell Short (4x) $s of SPY
While we believe that no trade is without risk, we get excited when the market hands us an opportunity. For those that are indecisive about the direction of the market, this trade offers respectable return potential. If the market heads lower and the banks' weakness foreshadowed a collapse, the banks are already heavily oversold and trading at historically low price/book ratios. If the market climbs higher, its probable that a positive outlook for bank lending growth will be a major contributing factor.
Alternatively, if you are more comfortable using ETFs instead of individual company names, then pairing long XLF (Financials) with short SPY is another idea. While the more diversified XLF is not as oversold relative to the Four Horsemen, the opportunity to gain through pairing is still a net 10%.