Pair Trade: Short QQQ, Long REMX

Includes: QQQ, REMX
by: Owen Williams, CFA


The Nasdaq-100 index has suffered significant technical damage.

The Market Vectors Rare Earth index has quietly been forming a 4-month basing pattern.

A notable reversal in relative strength performances in the two indexes.

Bearish position on U.S. Cyclicals and Bullish position on Chinese growth.

Since August 2011, the Nasdaq-100 index is currently up +76%. Over the same period the Market Vectors Rare Earth and Strategic Metals index is now down -62%. We currently see an opportunity for active investors to enter a 3 to 6 month trade to profit from this enormous price discrepancy.

We present first the technical argument against the Nasdaq-100, then the technical case for the MV Rare Earth index and finally some fundamental reasoning for the trade. We recommend using the Powershares QQQ tracker for the bearish stance and the REMX Market Vectors Rare Earth ETF for the bullish trade.

The Nasdaq-100, we believe, is forming a complex topping pattern that should take several weeks (see A Novel Idea: Sell U.S. Stocks Into Strength). While the index managed to avoid making it first lower low since 2011 (see chart below), we note that many leading tech companies and related indexes have already broken lower (check out the DJ Internet Composite or the Solactive Social Media index as examples). We see the potential for a head-and-shoulders pattern on the Nasdaq-100. Why ? We have a confluence of three factors that will combine to form a strong resistance around 3620-3600:

1.) The Nasdaq-100 has broken key support on the chart below (shown by green arrows). Old support often becomes a resistance level.

2.) The new falling resistance line from the March top

3.) The 61.8% retracement from the March top arrives at 3614

In addition, the current rebound (the "second shoulder") is being formed on lower volume, typical of a head-and-shoulders pattern. The connection of the two troughs forms the neckline at 3414. This is also the same level as the 200-day moving average, a key level due to the influence on trader sentiment.

The MV Rare Earth broke above its major downward sloping resistance in February (see red arrows on chart below). Since December 2012, the index has been "basing", an important pre-condition before reversing a multi-year down trend. On April 10, the index broke above the rectangular consolidation figure on the chart. This date is significant in that the Nasdaq-100 fell -3.13% on the same day.

So that brings up the question of relative strength, an important element in our models. In our modeling we calculate a cointegrating vector between the index under analysis and the Bloomberg All-World index, which serves as our benchmark proxy. The next chart shows that the relative performance of the Nasdaq-100 (green line) has indeed formed a lower low. In our experience, this type of relative weakness tends to persist long enough to make a trading profit. At the same time, the MV Rare Earth index has stopped underperforming since last November. Again, the long basing pattern of the relative strength line is reassuring that all the negative news has been priced into the MV Rare Earth index.

As for fundamentals, we would agree that U.S. growth is recovering and the Fed remains friendly. Everyone knows this and it is priced into the Nasdaq-100. For U.S. stocks to go significantly higher, (1) growth must exceed current expectations and (2) the Fed must continue to stimulate. We find it quite unlikely that the Fed will decide to reverse course and continue to push on the gas pedal, especially if consensus growth forecasts play out. On the other side, China has much more room - and political will - to embark on more stimulus measures. Poor macro data out of China increases the chances that the government will take steps to boost growth, including the first cut in almost two years to the lenders' reserve requirements. The Chinese are serious about protecting the growth target. The Rare Earth sector is nothing more that a play on Chinese growth. The underperformance of the Shanghai Stock Market over the past four years is reflected in the MV Rare Earth index. We recall readers that the U.S. market is at an all-time high while the Shanghai Composite is near a 6-year low. As for this pair trade, the author recalls three lessons learned in kindergarten which serve him to this day:

1. Learning the alphabet A to Z

2. Learning the number system 1 to 20

3. Learning to buy low and sell high

As a final note to traders, we recommend maintaining shorts on the Nasdaq-100 but lightening up if the index gets above 3620 and especially 3670. For longs on the REMX tracker, shorter-horizon traders might want to lighten up under $36.40-$36.00, which would mark a reentry into the rectangular consolidation figure. Longer-horizon traders should be comfortable as long as the tracker keeps above the lower end of the basing pattern.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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