Why Pair Trades Aren't Working

Editor's Note: The following article was written by Raymond James Chief Investment Strategist Jeff Saut.


I recalled the lyrics “and a partridge in a pear tree” when an institutional account asked me for some “pair trade” ideas. Recall that “pair trading” is considered a market-neutral strategy whereby you match a long position in one stock while selling short an equal dollar amount of another stock that's strongly correlated with the long stock position. Then, if the correlation weakens, hopefully your long position rises while your short position falls. For example, from my firm's research universe a pair trade might consist of buying Regal Cinemas (RGC) and selling short an equal dollar amount of Speedway Motorsports (TRK). For guidance, I called one of the smartest pair traders I know. His response was, “Don’t do it!” “Why?” I asked. “Because correlations are as high as they've been since 1987,” he replied. Further research reveals that he’s right, for arguably the best pair trading hedge fund in the business is down 11% year to date. Here’s why.

The chart below shows the correlation of S&P 500 stocks to the S&P 500 Index. Studying the chart one finds that the correlation from September 2009 through early May 2010 ranged between 55-65. However, following the May 6 “flash crash” the correlation leaps to ~78 and eventually ~82, which is indeed the highest correlation since the 1987 crash. So what caused this fairly rare event? In my opinion it's because the retail investor -- disgusted with high-frequency trading, dark pools, trading huddles, inter-market sweep orders, and so forth -- simply left the game, leaving the “pros” to trade among themselves. Obviously, when the alleged “dumb money” left the party, correlation had to rise. Adding to the situation: exchange traded funds (ETFs). To wit: When volume increases in, say, the Powershares Consumer Discretionary ETF (PEZ), that ETF automatically goes in and buys all 60 of the mid-cap stocks within the fund. Plainly, that causes correlation to rise.


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The conclusion from my brief study is that pair trades aren't working. Consequently, to make money you must take only one side of a position, either long or short. A potential insight is that as correlation recedes it might imply retail investors are returning to the equity markets. Currently, however, this isn't the case, for as repeatedly stated, "I haven't seen retail investors so unwilling to discuss stocks since the fourth quarter of 1974." That gleaning is reflected by the sentiment figures and the money flows out of equity mutual funds. With such a dour mindset, I think "something’s gotta give." That belief is driven by the fact that corporate profits continue to explode. Indeed, with 99% of the S&P 500 (SPX) companies reporting, operating earnings for the second quarter of 2010 have increased roughly 52% year-over-year to $21. Ladies and gentlemen, the peak in quarterly earnings tagged $24.06 a few years ago. Hence, we're roughly $3 away from bettering all-time peak earnings! Currently, this year’s earnings estimates for the SPX are hovering around $83, while next year’s are sticky around $95. The question then becomes, “What price-to-earnings multiple will Mr. Market put on said earnings if those estimates prove accurate?”

Alas, that's always a difficult question because the stock market is truly “fear, hope, and greed only loosely connected to the business cycle.” Some negative nabobs suggest that the P/E multiple should be in the single digits. Other, more optimistic types argue that with interest rates and inflation exceptionally low the P/E multiple should be 20x. The right answer is probably somewhere in the middle. Using a median P/E multiple of 15x yields a price objective of 1425 for the SPX based on a $95 estimate. Using a 12x P/E multiple renders an 1140 price target. Yet one inquisitive portfolio manager asked me, “Jeff, how do you arrive at that $95 number?” I responded that I don’t engage in such exercises, preferring to try and get things directionally correct. I then proceeded to relate to him what one of Wall Street’s best and brightest stated on a recent conference call. The speaker was Dr. David Kelley, strategist for JPMorgan Funds, and he had this to say (as paraphrased by me):
 

I arrive at my $95 earnings estimate for the S&P 500 in 2011 by assuming interest  rates stay below 4%, nominal GDP grows at 5.8%, a 2% hop in productivity, and with unit labor costs falling by -0.3%. Considering that unit labor costs have fallen by -2.1% for the second year in a row, this isn't an unreasonable assumption. If correct, at least in real terms, the value of output per laborer is increasing faster than workers’ wages. Inasmuch, the gains in productivity are accruing to corporations. Add in low depreciation expense and the result is a profits explosion.

Obviously, that forecast foots with my belief that we remain in a “profits recovery” whereby profits soar, leading to an inventory rebuild that drives a capital expenditure cycle. Then, and only then, companies begin hiring, which fosters a pickup in consumption. Ergo, with surging profits bringing the SPX’s earning’s yield to 8.5% ($95 ÷1110), I keep chanting, “I think it is a mistake to get too bearish here.” Verily, if we were on the verge of a big decline it seems rather odd that many of the world’s stock markets are strengthening with some of them actually trading to new recovery highs. If past is prelude, such action suggests the weaker markets should soon follow. And, that’s what our stock market has done over the last two weeks, causing the SPX to break above its recent reaction high of 1105. My sense is we’ll see more near-term upside with the SPX then stalling around 1115-1120, attempting to pull back without much traction, and then re-rallying. Eventually, I think we'll break out above the August recovery high (1130).