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

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