Note: Banking on Financials members received a detailed review of this trading strategy in December 2016.
We believe it would be very naive of us to claim that long-only investors do not observe trading dynamics to improve the timing of their entry/exit points. On this basis, we have developed several short-term trading strategies in the global banking space. It is key to note that our trading strategies are based on fundamental analysis. While we do observe trading dynamics in our strategies, we do not use popular trading indicators such as MACDs or RSIs.
In this article, we discuss a pairs trading idea. By definition a pairs trade is a market neutral trading strategy that matches a long position with a short position in a pair of highly-correlated stocks. The strategy works not only with stocks, but with other market instruments such as bonds, commodities or currencies. However, stocks are still the most popular asset for pairs-traders. This simple-yet-effective method is among the most widely used hedge fund strategies.
As the chart below shows, historically, there has been a very strong correlation between Itau and Sberbank.
Indeed, it is a classic pair of highly-correlated stocks. But what is the fundamental rationale behind this correlation?
Firstly, we note that there is also a correlation between the respective currencies: the Brazilian real (BRL) and the Russian rouble (RUB). The correlation can be in large part attributed to the fact that both BRL and RUB are the so-called commodity-currencies, i.e. currencies of countries that depend heavily on the export of certain commodities. The below chart demonstrates that BRL and RUB are dependent on oil (NYSEARCA:USO) prices.
Secondly, Itau and Sberbank have much in common. They enjoy dominant market positions in their respective markets, operate extensive branch networks and have higher-than-peer net interest margins. As a result, the banks' profitability levels are among the highest in emerging markets and globally.
Thirdly, historically, Itau has traded at a 50-60% premium to Sberbank on a P/B basis. The premium has diverged from this level several times due to various events (for instance, the impeachment of Dilma Rouseff or the EU/US sanctions regime on Russia). However, the premium's average level is close to 50-60%.
We have been using this pairs trade since the beginning of 2015, and it has given excellent results so far. When the correlation between the stocks temporarily weakens, i.e Sberbank moves up while Itau moves down (or vice versa), the trade would be to short the outperforming stock and to long the underperforming one.
Source: Renaissance Research, Bloomberg
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