We certainly do live in interesting times. Over the past three years, even the most grizzled veterans of the trading markets have witnessed events that they had never imagined: the evaporation of Lehman Brothers, the near-collapse of the world's entire financial system and the ongoing drama that will determine the future of Europe, to name a few. Spinning off of these historically significant events are situations that offer less drama but perhaps more in the way of actionable, tradable situations.
For example, you may have heard this tidbit, which has been widely reported over the past few days. According to a report by Birinyi Associates, the correlation between the stocks in the S&P 500 index and the index itself is at its highest point ever, registering a reading of 0.85. A reading of 1 would indicate perfect correlation.
This is telling us that stocks are trading in lockstep. The good, the bad and the ugly among them are moving up and down not on the basis of fundamentals but on reactions to news from Europe and elsewhere. If we take this logic a step further, it means that some stocks and sectors should be outperforming the market and some should be underperforming -- but they're not, because the entire market has turned into one big trade.
Correlations come and go, and while I have no idea how long this particular correlation will last, it seems to be one that could end soon. Another earnings season on the way, so perhaps stocks will soon trade on fundamentals once again. I realize it's hard to believe now, but the day will come when our entire lives do not revolve around the latest European rescue package or the latest statement from "Merkozy" or any of the various and sundry European finance ministers and their minions. That day may come sooner than we believe.
Assuming a return to normalcy, stronger sectors should outperform weaker sectors regardless of market direction. Since the main focus of the markets is currently the financial sector, I'll avoid that one for the time being; there is simply too much noise and emotion tied to the banks right now.
Going into earnings, I like the S&P Retail ETF (XRT). This investment vehicle contains names such as PriceSmart (PSMT) and AutoNation (AN). This ETF is up about 1% year to date.
I'm going to play XRT against the S&P Homebuilders ETF (XHB), which has top holdings such as Ryland Group (RYL) and KB Homes (KBH). XHB is down nearly 20% year to date. I'm not fond of the homebuilder sector, from either a fundamental or technical perspective. I'm essentially trading retailers vs. homebuilders (long XRT, short XHB).
Here's my theory in a nutshell: If most stocks are trading lockstep with the S&P 500, that means both outperformance and underperformance could be understated. If and when we return to a more normal scenario where stocks and sectors are less influenced by outside news and trade on their own merits, the strong sectors should outperform the weak ones by a greater margin.
This trade may play out over a longer period of time, but I do like the market-neutral aspect of it. In other words, I believe XRT will outperform XHB regardless of whether stocks rise or fall. Until the S&P breaks out of its current range and the next trend emerges, my thinking will be more along these lines.