Relative Value Trades Revisited

 | May 01, 2014 | 1:00 PM EDT  | Comments
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Stock quotes in this article:

xlb

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XLK

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xle

If you've been following my writing, you know that I've been pretty bearish on tech over the last four to six weeks. I also have been right, which is nice. But I haven't made enough money because I wasn't big enough. For the record, there are only two positions available: wrong, and not big enough.

But I also said that the beat down in tech would become a giant risk-off move throughout the financial markets, and that just hasn't happened. I thought it would spread into corporate credit, and that just hasn't happened. Not only has it not happened, but the Dow put in a new all-time high! Doesn't look risk-off to me. It looks like a really big sector rotation, at least for now.

If that is all it turns out to be, we can still work with that. Correlation is low and sector dispersion is high, and instead of stock picking (which can be hard) we can go back to old-fashioned sector ETF relative value trades. I have much experience with this.

I still believe tech and growth is wildly overpriced, and I believe miners are the cheapest stocks on the board. Energy is looking more and more attractive from a technical standpoint. Why not be long Materials Select Group SPDR (XLB) and Energy Select Sector SPDR (XLE), and short Technology Select Sector SPDR (XLK)? This was how I made a living trading prop at Lehman, doing trades like these. Sometimes the moves can be dramatic.

You have to think about what this looks like, with the Dow (which arguably represents value) putting in all-time highs while the Nasdaq is a technically- weak disaster. The thing with sector and style trades is that they can go on for a long, long time.

The biggest one ever was during the tech bear market, when growth was ruthlessly marked down, day after day. And value, especially the small-cap value corner of the style box, had some of its best years ever.

These kinds of trades were difficult to do just a few years ago. Remember when everyone was complaining that correlation was so high, that you couldn't pick stocks anymore? And they were blaming it on ETFs?

They never did figure out why realized correlation was so high, but most problems will resolve themselves if you leave them alone long enough. We are in a stock picker's market, and better yet, a sector picker's market.

Most professionals do relative value trades almost exclusively. Long something, short something else against it.

Even the Canadian bank trade -- my losing short Canadian bank trade -- is better expressed alongside being long U.S. banks. This trade has worked great over the last two years, and where short Canadian banks has been a terrible trade, long U.S. banks against it has been superb. That's relative value.

So short tech can turn out to be wrong, but short tech and long energy and materials could turn out to be right if energy and materials go up more. Once again, this goes back to the age-old question, do you want to be right or do you want to make money? 

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