Heading into last week's election and the Federal Reserve's
latest stimulus efforts, the stock market looked set to pause.
After all, the major indices had been in rally mode since late
August and bargain prices were harder to find. Yet the market
rallied even further late last week, returning stocks to pre-Lehman
crisis levels. But this is no time to be complacent: even as the
market looks healthy, it could just as easily falter at this point
winds down and market-moving catalysts don't appear on the
Rather than try to bet on the market's direction, you're better off
focusing on specific investment plays. And even as you stand by
your bullish picks, it makes sense to offset them with equally
bearish picks. This "market neutral" approach, known as paired
trading, should do well regardless of which way the broader stock
In a paired trade (called by some a "pair trade"), you go long with
a stock in a certain industry and make a corresponding short
investment on an industry peer that looks less attractive. For
example, you may like the prospects for steel maker
but are concerned about the broadereconomy and its impact on steel
stocks. So you could short rival
U.S. Steel (
if you thought that it would not benefit as much in a scenario of a
With that in mind, here are three current pair trades that I like:
1. AMR (long) vs. UAL (short)
The challenge of paired trades is not simply to find a company that
is operating at peak levels and correspondingly bet against
companies that are performing weakly. Instead, you want to gauge
where those companies may be in the next 12 to 24 months, and how
their shares are currently valued. In that context,
, which is currently an airline industry laggard, and
United Continental (
, which is reaping the benefits of a solid
, are a play on reversing fortunes.
United Continental is posting great numbers right now -- revenue at
each of the two airlines jumped sharply in October -- and analysts
have been talking up shares based on the myriad synergies that the
merger willyield . As a result, shares have tripled in the last
year -- reflecting all of the
gains yet to come.
Meanwhile, AMR has been struggling with high labor and pension
costs, and stubborn operating losses, and has only recently joined
the airline sector rally. But looking ahead, it may be AMR's turn
For starters, AMR has a high degree of exposure to the North
America-South America travel market, which is expected to be
characterized by restrained supply growth but rising demand in
2011. Carriers like AMR tend to operate international flights much
more profitably than domestic flights, and booming economies in
Brazil, Colombia and Chile should allow this region to be highly
profitable for AMR.
Second, AMR has spent much of 2010 focusing on shoring up its
underfunded pensions and upgrading its aging fleet. Those expenses
are expected to be sharply lower in 2011, which should help
free cash flow
) to soar. Barclays estimates that AMR could generate $750 million
in FCF next year, yet the company's stock is valued at less than $3
billion, equating to a FCFyield of around 25%. According to
Barclay's that's the highest in the sector.
Much of this call resides on external conditions such as demand for
air travel and oil prices. Those factors may help or hurt in 2011.
By focusing on a pair trade, you can remove these possible factors
and stock market risk.
2. NuVasive (long) vs. Intuitive Surgical (short)
In the past two decades, surgeons have seen a revolution in terms
of spinal surgery. Thanks to companies like
Intuitive Surgical (Nasdaq: ISRG)
, patients now have a much better chance of exiting the operating
room with a hoped-for end to chronic back pain and disability. In
recent years, industry upstart
NuVasive (Nasdaq; NUVA)
has also appeared on the scene with a set of surgical tools that
set a newbenchmark for minimally invasive spinal surgeries
thatyield faster recoveries. The company's sales surged from $50
million in 2004 to nearly $500 million this year. Management has
laid out plans to fuel further growth by training more doctors in
the United States on its platform of tools and expanding
At least here in the U.S., those growth plans may have to slow a
bit in the near-term as the company recently warned that the
changing healthcare landscape is leading many patients to defer
elective surgery. To be sure, NuVasive's approach represents real
cost-savings for health care insurers thanks to improved patient
outcomes and shorter hospital stays. Shares of NuVasive have fallen
-45% from their 52-week high on concerns that sales growth will
slow to +10% to +15% next year. Yet if that's the case, then
forecasts that rival Intuitive Surgical will boost sales nearly
+20% next year looks too optimistic.
So by my math, shares of NuVasive will rebound nicely if near-term
growth concerns prove overblown. Or shares of Intuitive Surgical
have ample room to fall if NuVasive's cautious view comes to pass.
This pair trade removes the element of risk associated with
forecasting sales trends in the spinal surgery market.
3. Christopher & Banks (long) vs. Liz Claiborne
Spending on women's apparel remains in a funk thanks to the weak
economy. And weak spending has been especially painful for
Christopher & Banks (
, which recently had to change leadership after seeing shares fall
from $30 in late 2006 to a recent $6. But this retailer still has
strong resonance with its customer base, and should see nice gains
once the economy improves. Sales growth is likely to be just +2% to
+3% next year, to around $475 million. But I look for sales to
rebound +5% to +10% in 2012, which should fuel
growth at a much faster pace. A return to a $10 or $15 share price
is not out of the question in such a rebound scenario.
Conversely, if the economy remains weak, then shares of
Liz Claiborne (
look increasingly vulnerable. Its shares have risen +50% since late
August. Those gains have partially come from a recent rebound in
gross margins, yet cotton prices have risen sharply in recent days
and analysts' forecasts of Liz Claiborne's profit levels may need
to come down.
If the economy rebounds, Christopher & Banks looks to have
. Yet if the economy doesn't rebound and rising cotton prices start
to bite, the recent strong rebound for Liz makes that stock risky.
Action to Take -->
Since we lack a crystal ball, immunizing your portfolio against
markets can be a prudent approach. AMR, NuVasive and Christopher
& Banks look cheaper than their peers on a variety of metrics.
They have more upside in a
, and likely less downside in a falling market. By pairing these
stocks with their bearish counterparts, you can significantly
reduce downside risk, while still enjoying the upside.
-- David Sterman
David Sterman started his career in equity research at Smith
Barney, culminating in a position as Senior Analyst covering
European banks. David has also served as Director of Research at
Individual Investor and a Managing Editor at TheStreet.com. Read
P.S. -- Any analyst can tell you they like a stock. But how many
are willing to put their money where their mouth is?
StreetAuthority Market Advisor is so confident in Nathan
Slaughter's picks that we gave him $100,000 in cash to put into his
recommendations. Learn how you can join in and profit along with
Disclosure: Neither David Sterman nor StreetAuthority, LLC hold
positions in any securities mentioned in this article.