Pair's Trading Update

We wanted to update our pair’s trading model. As we mentioned in previous posts (Defensive Positioning and Pair's Trading and Our Thoughts On The Economy) we commented that we are positioning ourselves defensively. A few of the new trades that we put on this week include:

Long Insurance (KIE) / Short Commercial Banks (KBE)

The relative score Z-score is over one standard deviation from the mean as banks have outperformed insurance companies of late and that trend continued through Jackson Hole.

This trade has been working for us as the insurance sector recently broke out of a trading range and momentum is strong.

The long insurance / short banks comparative chart shows the periods in the past when we had a bearish MACD cross coming off of an oversold RSI oscillator. The red arrows signify the periods when the relative performance Z-score was beyond one standard deviation.

The banking ETF has been rallying on the notion of one or two rate hikes this year. In our last blog we expressed doubts towards the economic picture and the economy’s ability to withstand additional hikes. Given the “data dependent” Fed, we believe a weak employment number this Friday could cast a shadow of doubt regarding further rate hikes. According to Business Insider, “Another strong lift in payrolls growth, along with a further acceleration in average weekly earnings, could potentially bring on a near-term rate hike from the Fed, perhaps as soon as September. Well, if history is any guide, hopes for a September hike based on strong payrolls growth in August may about to be dashed.

According to analysis from Richard Franulovich, Westpac’s New York based G10 FX strategist, August payrolls growth almost always undershoots market expectations, whether looking back five years or two decades.

The chart below from Westpac shows the average deviation from consensus forecasts for payrolls growth for every month of the year. Second only to March, August has the largest downward deviation from forecasts for any given month, averaging a miss of 49,000 over the past five years and 38,000 over the past two decades.”

A big miss this Friday could put pressure on the financial sector and banks specifically.

Long S&P 500 (VOO) / Short Industrials (XLI)

The VOO/XLI relative performance Z-score has fallen below one standard deviation from the mean and has started to head higher indicating expected relative underperformance of the industrials sector relative to the general market.

If we are correct in our defensive stance over the next few weeks and months, then one would expect the cyclical industrials sector to underperform. On the daily XLI chart it appears the momentum within the sector is waning and we are possibly seeing bearish divergences from RSI and MACD against the pricing action of XLI.

On the daily relative price performance chart, the industrials sector seems to be hitting resistance and momentum is fading relative to the S&P 500.

Long S&P 500 (VOO) / Short Energy (XLE)

The VOO/XLE relative performance Z-score hit minus one standard deviations and has quickly recovered.

On the VOO/XLE relative performance chart we noticed that RSI has fallen below the 50 level and we are getting close to a bearish MACD daily cross. On the weekly MACD we received a bearish cross a few weeks ago but the recent rally couldn’t bring the MACD line above the signal and it appears we are heading lower again.

Model Performance

 We have spent the last two weeks building positions and preparing for a September market softening. We anticipate a rotation back into economically defensive positions and exit those cyclical sectors. As we wait for our thesis to materialize we have accumulated small losses in the account. The two pair’s trades that are largely responsible for our losses are the long health care services (XHS) / short S&P 500 (SPY) and long health care (XLV) / short S&P 500 (SPY). Starting with the Mylan pricing controversy the overall health care sector has been a huge underperformer. The losses are small and haven’t reached our stop loss but we are looking for improving pricing action and may be adding to these positions over the coming weeks as we believe the Mylan sell-off was way overdone.

The portfolio metrics are starting to come in. As of 8/31/16 we have placed 9 pair’s trades and 4 are currently profitable or 44.4%. Our average holding period is 8 days and our average return per trade is -0.23%. The performance thus far puts us down 1.4% for the month of August (not including fees and start-up costs).

Joseph S. Kalinowski, CFA

No part of this report may be reproduced in any manner without the expressed written permission of Squared Concept Asset Management, LLC.  Any information presented in this report is for informational purposes only.  All opinions expressed in this report are subject to change without notice.  Squared Concept Asset Management, LLC is a Registered Investment Advisory and consulting company. These entities may have had in the past or may have in the present or future long or short positions, or own options on the companies discussed.  In some cases, these positions may have been established prior to the writing of the particular report. 

The above information should not be construed as a solicitation to buy or sell the securities discussed herein.  The publisher of this report cannot verify the accuracy of this information.  The owners of Squared Concept Asset Management, LLC and its affiliated companies may also be conducting trades based on the firm’s research ideas.  They also may hold positions contrary to the ideas presented in the research as market conditions may warrant.

This analysis should not be considered investment advice and may not be suitable for the readers’ portfolio. This analysis has been written without consideration to the readers’ risk and return profile nor has the readers’ liquidity needs, time horizon, tax circumstances or unique preferences been taken into account. Any purchase or sale activity in any securities or other instrument should be based upon the readers’ own analysis and conclusions. Past performance is not indicative of future results.

Our Thoughts On The Economy

The word out of Jackson Hole is that the Fed is prepared to raise rates once or twice this year depending largely on the economic data over the next several weeks and months. The markets are placing a 36% chance of a rate hike during the September meeting and 59% chance of a hike in December.

We’re a bit skeptical if the U.S. economy and the stock market could easily absorb these expected hikes. The economic data that we are viewing doesn’t appear all that encouraging.

The flattening yield curve (two and ten-year yield) give us cause for concern.

NFIB small business optimism has been improving somewhat but remains below trend.

The year-over-year growth rates of real personal income, non-farm payrolls, retail sales and industrial production all seem to be trending below average.

We like to aggregate the manufacturing indices into one chart. Our reading includes; ISM, Chicago, Dallas, Richmond, Philadelphia and New York manufacturing surveys. This measure has been trending below average for quite some time.

Truck tonnage is still positive year-over-year but trending lower and total year-over-year rail shipments remain negative. We have always considered the movement of “stuff” as a great leading indicator of economic strength so we’re not very excited about a strong economic rebound on the horizon.

The Conference Board Leading Economic Index is still positive year-over-year but heading in the wrong direction.

LEI year-over-year growth in building permits, average hours worked, credit index and new orders all seem to be weakening as of late.

The Atlanta Fed’s GDPNow is forecasting 3.5% GDP growth in the third quarter. This reading has been fairly accurate over the past year and we’ll be watching it closely. The New York Fed’s Staff Nowcast Report is estimating 2.8% for 3Q GDP.

Here is our Thesis. The economic numbers have been lackluster over the past several quarters and we are not seeing much of an improvement recently. Perhaps the expectations are too high and that is reflected in the market. Notice the Financials and Technology are the two sectors that have supported the market over the past month.

As we mentioned in our last blog Defensive Positioning and Pair's Trading we are taking a defensive stance towards the market. We expect the month of September to be weak as has been the case historically.

Bottom Line: We are not in the camp that the economy is as strong as the Fed is projecting. That said we do not believe a recession is in the making currently. We anticipate a pullback in the market for September. We have taken an oversized cash position in our core portfolio heading into September and have been building defensive positions in our pair’s trading portfolio. We will stand ready to re-deploy capital on a pullback.

 Joseph S. Kalinowski, CFA

Additional Reading

ART CASHIN: 2 'potential landmines' should keep the Fed on hold in September – Business Insider

The 11 Bone-Chilling Things I Gleaned from Yellen’s Chart – Wolf Street

FOMC Vice Chair Stan Fischer Endorses Negative Rates – Seeking Alpha

No part of this report may be reproduced in any manner without the expressed written permission of Squared Concept Asset Management, LLC.  Any information presented in this report is for informational purposes only.  All opinions expressed in this report are subject to change without notice.  Squared Concept Asset Management, LLC is a Registered Investment Advisory and consulting company. These entities may have had in the past or may have in the present or future long or short positions, or own options on the companies discussed.  In some cases, these positions may have been established prior to the writing of the particular report. 

The above information should not be construed as a solicitation to buy or sell the securities discussed herein.  The publisher of this report cannot verify the accuracy of this information.  The owners of Squared Concept Asset Management, LLC and its affiliated companies may also be conducting trades based on the firm’s research ideas.  They also may hold positions contrary to the ideas presented in the research as market conditions may warrant.

This analysis should not be considered investment advice and may not be suitable for the readers’ portfolio. This analysis has been written without consideration to the readers’ risk and return profile nor has the readers’ liquidity needs, time horizon, tax circumstances or unique preferences been taken into account. Any purchase or sale activity in any securities or other instrument should be based upon the readers’ own analysis and conclusions. Past performance is not indicative of future results.

Defensive Positioning and Pair's Trading

We just wanted to take the time for a brief portfolio update. We took long positions on the Brexit sell-off (around SPX 2000). We moved money into biotech, commercial & regional banks, capital markets and transports. The sectors had done well and we spent the last week taking profits. The markets seem to be consolidating and stalling and could be prone to weakness over the next several weeks.

We are entering a traditionally weak part of the year and the upcoming election season could exacerbate volatility in the near future. The chart below via Business Insider shows the seasonality of returns on a monthly basis.  

With the VIX sitting at such benign levels, it makes sense that the market will at least stall and consolidate if it doesn’t correct at some point. With the upside potential of the markets currently stymied by complacency and considering our gains in the portfolio from the Brexit bounce, we believe the best course of action is to raise cash and wait for a more enticing entry.

On the SPX daily, the bull run appears tired as most oscillators and the MACD have all turned lower and volume is thinning.  There is also a bearish divergence between the percent of stocks in the S&P 500 trading above their 50D moving average and the overall index (%SPXA50R on the chart below). A pullback to 2120-2130 would be a welcome event and allow us to reposition ourselves.

The daily Nasdaq has the same chart risks as the SPX. Make note of the bearish MACD cross that occurred last week.

Outside of raising cash and writing options against our core positions we are contemplating adding smaller positions of silver and the U.S. dollar to the portfolio. As far as silver is concerned, the precious metal is oversold on both the RSI (5) and fast stochastics oscillators although we will wait to see if the RSI (14) trend can retake the 50 level that it has held from the start of the year. We would also like to see MACD turn higher off this support level. Should some renewed signs of strength emerge, we will take our position. The weekly silver chart shows the uptrend of 2016 remains intact with the oscillators holding above their midpoints and the MACD remains in a rising pattern. Silver is sitting on its 200W moving average.

The US dollar has weakened recently as can be seen in all the oscillators. The MACD histogram and all the oscillators have started to turn higher last week as the dollar approached what appears to be near-term support. On the weekly US dollar chart we can see a flagging pattern off its parabolic run from last year. The more sensitive oscillators are oversold at this point but the MACD remains in a bullish pattern. We will most likely take smaller positions in both silver and the US dollar but will certainly wait until the outcome from Jackson Hole this week before moving in a more aggressive fashion.

Pairs Trading Model

We have recently launched a new fund strategy that utilizes a heavily levered portfolio in creating a long/short dynamic with the intensions of capturing spreads due to distortions in relative pricing performance.

Our objective is to create a long/short portfolio that minimizes portfolio volatility and attempts to capture pricing spreads between the long and short positions. We will use models that attempt to capture the behavioral dynamics between two like securities allowing us to profit by buying the instrument with the greatest probability of outperforming on a relative basis against our secondary offsetting instrument.   

We are using a relative performance z-score between two like securities to assist in determining potential rotation opportunities. Similar to technical analysis, we will be using several objective signals to recognize potential profit opportunities. We will also utilize relative strength of the combined performance of the two instruments.

Once the trading criteria is met, we then confirm the correlation between the two instruments. A high positive correlation is preferred to confirm our directional bias, i.e. long/short. Two instruments with a strong negative correlation and a long/short structure is in essence a one-sided position.

In order to account for volatility, we choose the appropriate allocation towards each trade. We accomplish this by using a recent beta test (six months). We run our covariance and variance to determine the beta between the two instruments presented. The beta applies to the primary instrument and the secondary instrument will be given a value of one. We will run the R-squared between the two to confirm correlation. Once the beta is calculated we apply 1-(Pb/Pb+1) where Pb is the primary beta to determine what percent of the trade is long and short.

Once we enter a position we calculate our potential downside risk using one, two and three standard deviation pricing variation of the two instruments over the past six months. As a stop loss, a one or two standard deviation movement against us will trigger the unwinding of the position. For profit taking purposes, it appears a one standard deviation increase between the relative z-score and its signal line (15 day moving average) is a good initial exit. We will most likely take one-third the position off at this level, another one third if it were to hit that level again and leave the balance in place until the z-score exhibits a bearish cross to its signal. We use a histogram to help assist us in this process.

The figure below represents our dashboard. This pulls all the relevant information from the models into one easy to read box that can be viewed real-time.

New Pairs Trades

Given our defensive stance in our core portfolio as mentioned above it doesn’t surprise us that the current pair’s signals we are receiving are defensive in nature.

Long Consumer Staples (XLP) / Short S&P 500 (SPY)

As can be seen from the relative performance Z-score below the pricing differential between the consumer staples sector and the S&P 500 have reached extremes. We like to see the pricing differential near -2 standard deviations from the mean as we put on the long/short position.

On the daily XLP, the index is sitting on its 50D moving average that has been a key support level for quite some time while RSI (14) and MACD are pointing higher. Given our hesitation about further market gains within the S&P 500 as mentioned earlier we find the risk reward dynamics for this trade to be quite favorable.

The next chart shows the relative price performance of the XLP (long) and the SPY (short). We have marked the instances when our relative price performance z-score reached extreme points (green arrows). We have also marked the corresponding periods when RSI (14) touched the 30 level and the corresponding bullish MACD cross. We have started to build on this position and expect a rotation to a more defensive stance over the coming weeks.

Long Insurance (KIE) / Short Financials (XLF)

The relative performance Z-score below the pricing differential between the insurance sector and the financials have reached extremes. We like to see the pricing differential near -2 standard deviations from the mean as we put on the long/short position.

On the daily KIE, the insurance ETF has been consolidating but nearing a potential breakout from resistance. The daily financials ETF chart shows a similar pattern but hasn’t approached its breakout level yet.

On the relative performance chart we have marked the three extreme z-score readings using green arrows. We have also highlighted the times when RSI (14) approached 30 and the bullish MACD crosses. We are also encouraged by the support the 200D moving average has provided. We consider these levels a key support area. We believe this pair’s trade offers a favorable risk/reward dynamic and we will continue to build a position over the next days and weeks.

Long Health Care Services (XHS) / Short S&P 500 (SPY)

The relative performance Z-score below the pricing differential between the health care services sector and the S&P 500 have reached extremes. We like to see the pricing differential near -2 standard deviations from the mean as we put on the long/short position.

The health care services ETF has gotten mauled over the past few weeks. Given its oversold condition and the possible near-term support we decided to add this pair’s trade to the portfolio. We would have greater confidence in the trade once we see MACD and RSI start to turn higher and will most likely add to the position should those events occur.

On the relative performance chart we have marked the extreme z-score readings using green arrows. We have also highlighted the times when RSI (14) approached 30 and the bullish MACD crosses. While this model has a less reliable history of buying opportunities, we will nonetheless take this position, albeit with a smaller average position size.

Long S&P 500 (VOO) / Short Technology (XLK)

The relative performance Z-score below the pricing differential between the S&P 500 and the technology sector have reached extremes. We like to see the pricing differential near -2 standard deviations from the mean as we put on the long/short position.

The daily XLK chart shows a relatively healthy tech trend recently but we have seen the RSI start to head lower from an extreme overbought position and the MACD has suffered a bearish cross last week. It the recent past, these events have been negative scenarios for the ETF.

On the relative price performance chart we have gotten several extreme readings over the past year. These signals have marked periods of weakness within the tech sector but the real win was in April of this year as Apple (AAPL) took its toll on the tech sector.

Bottom Line: In both our core equity portfolio and our newly launched pair’s portfolio we are taking a defensive stance over the next several weeks. Given the historically soft seasonal and election year equity patterns we are waiting for at least a brief pullback before we increase our exposure to more cyclical sectors and higher beta instruments.

Happy Trading

Joseph S. Kalinowski, CFA

 

Email: joe@squaredconcept.net

Twitter: @jskalinowski

Facebook: https://www.facebook.com/JoeKalinowskiCFA/

Blog: http://squaredconcept.blogspot.com/

Web Site: http://www.squaredconcept.net/

 

No part of this report may be reproduced in any manner without the expressed written permission of Squared Concept Asset Management, LLC.  Any information presented in this report is for informational purposes only.  All opinions expressed in this report are subject to change without notice.  Squared Concept Asset Management, LLC is a Registered Investment Advisory and consulting company. These entities may have had in the past or may have in the present or future long or short positions, or own options on the companies discussed.  In some cases, these positions may have been established prior to the writing of the particular report. 

 

The above information should not be construed as a solicitation to buy or sell the securities discussed herein.  The publisher of this report cannot verify the accuracy of this information.  The owners of Squared Concept Asset Management, LLC and its affiliated companies may also be conducting trades based on the firm’s research ideas.  They also may hold positions contrary to the ideas presented in the research as market conditions may warrant.

 

This analysis should not be considered investment advice and may not be suitable for the readers’ portfolio. This analysis has been written without consideration to the readers’ risk and return profile nor has the readers’ liquidity needs, time horizon, tax circumstances or unique preferences been taken into account. Any purchase or sale activity in any securities or other instrument should be based upon the readers’ own analysis and conclusions. Past performance is not indicative of future results.