Break From Volatility With Market-Neutral Strategy

by: Kurtis Hemmerling

Are you one of the many investors that are ambivalent on the market direction? Long-term bulls point to the strong corporate earnings and low valuations while bears direct our attention to the sovereign debt crisis where world powers struggle come up with a solution that will help both individual and the broad economy.

When indecision is high, a long/short equity strategy is one method you can use. You go long one stock while simultaneously going short another. If your long pick rises quicker than your short in a bull market, or if your short pick falls faster than your long in a bear market, you are left with excess gain.

This is a similar concept to pairs trading, which is a mean-reverting strategy. In pairs trading you may note some fundamental or technical deviation which you capitalize on with the expectation that prices will come back to former averages. In this article, we will simply be suggesting going long on a basket of stocks that have a stronger than average upside potential in bull markets while shorting weaker stocks that often fall faster in bearish markets. This will not be classical pairs trading, although it is still a market-neutral strategy.

Creating the Strategy

We will be holding our long stocks for only 2 weeks at a time. Our long picks will be based on stocks with some form of upgraded forecast – such as a 5% estimated earnings jump for next year or a bump in analyst recommendations. We will also look for a recent earnings surprise that often gets the attention of investors.

Our short picks will be based on weaker stocks in the S&P 500, with 12 month trailing operating cash flows below zero, in the bottom half of return on equity in the S&P 500, with an eye on next year's earnings revisions. While these short picks have been tested below using 2 week holding periods, the results remained strong up to 3 months. Therefore, you can switch your long picks every 2 weeks, but you can hold your short picks up to 3 months if you so choose.

The upgraded-long strategy was tested over 550 times during the past 10 years. It rose 4.4% on average in up markets and fell 2.79% in down markets. The short strategy was run through the same test. It made 5.33% on average in down markets but lost 3.67% in up markets. We might expect 0.73% gains every 2 weeks in up markets and 2.54% gains in down markets when trading these stocks. Of course, these are broad averages only.

Long Picks

Douglas Emmett Inc (NYSE:DEI) – By the time you are reading this, earnings will likely have been released (although not available at time of writing). Over the past few months the expected earnings for next year has jumped, we have experienced some decent quarterly earnings surprises, and a positive trend on analyst recommendations has been noted. Another earnings surprise of 8% or higher, combined with positive forward-looking estimates, would make this a candidate. I’m always a little jittery around earnings as it is the one time that much of your analysis goes out the window as you roll the dice and hope.

American Railcar Industries (NASDAQ:ARII) – A large surprise last quarter prompted some upgrades in earnings forecasts. The average recommendation on this is a buy. A big backlog and jumping profits makes this the right time to jump aboard the train.

RTI Biologics Inc. (NASDAQ:RTIX) - A large earnings surprise followed by a modest revision in next year's earnings makes this a stock to pick up. The next 5 years have high growth expectations of just under 30% annually – but remember, we are only taking these stocks for short rides during periods of high indecision.

Short Picks

Our short picks look only to the S&P 500 index with stocks that have negative operating cash flows (quarterly or annually) and a low return on equity. We also consider if a company has falling operating cash flows between last quarter and last years quarter. This has been a profitable shorting strategy over the past 10 years.

Lennar Corporation (NYSE:LEN) – Sliding operating cash flows, reductions in next year’s earnings forecast make this one suspect in a down market. However, you should weigh this against a pop in analyst recommendations and the trend for the company to beat earnings forecasts with positive surprises. As well, the last month has been very positive in price movement. We are not saying that this stock will go down overall, we are betting that it will fall harder and rise slower than our bull picks.

Archer Daniels Midland Company (NYSE:ADM) – The average analyst recommendation on this stock has inched down ever so slightly, although still in buy territory. Recent earnings were a bit of a miss with an adjusted 58 cents per share. Next year’s earnings have been trending down over the past few months.

Sears (NASDAQ:SHLD) – Fundamentals continue to slide on Sears as total shareholder equity gets lower and lower every quarter. While many are betting on Lambert to turn things around in the long-term, we have yet to see proof of this in the short-term. Next year’s earnings forecasts have fallen from negative 32 cents 90 days ago to negative 82 cents by today’s aggregate estimate. A big jump from low 50s to low 80s in just over one month might see this taking a breather, as there is a lot of credulity factored into the price - although shares to short are extremely difficult to come by.

Two other possible shorting recommendations are PulteGroup (NYSE:PHM) and AK Steel Holding Corporation (NYSE:AKS).

As for timing, while signals are being generated on all of these stocks, you should be aware that sharp two-day pullbacks are often followed by a short pop upwards as swing traders play over-bought and over-sold conditions. Your short-picks have a higher chance of a sharp, although short-lived, upwards pop if you initate positions following a two-day drop. It might be a small matter, but it could have a negative effect since your shorted stocks might jump quicker than your bull picks over a day or two due to a poor technical entry.

Understanding the Recommendations

We are not making any judgments that the market will go up or down with this strategy. We are not saying that the short picks will drop in value or that the long picks will go up in value. Both stocks could rise and both stocks could drop for our strategy to work.

This strategy makes gains by comparing two picks or baskets of stocks. If both stocks rise with the market, we hope that our long picks will go up a bit farther than our shorted stocks. Both stocks could drop as we hope our short picks fall a little bit faster. This is a relative strategy and you should not buy or sell any of the stocks listed in isolation. This strategy makes no inferences on the up or down direction of an individual stock, only how its performance might be in relation to another broad category of stocks. As you watch the market and try to guess the next move, consider taking a much needed breather for the next month by trading a long/short equity strategy that takes a neutral position while still positioning your portfolio for gain.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.