“And a Partridge in a ‘Pair' Tree”

By Raymond James I recalled the lyrics “and a partridge in a pear tree” when an institutional account asked me for some “pair trade” ideas. Recall that “pair trading” is considered a market neutral strategy whereby you match a long position in one stock while selling short an equal dollar amount of another stock that is strongly correlated with the long stock position. Then, if the correlation weakens, hopefully your long position rises while your short position falls. For example, from our research universe a pair trade might consist of buying Regal Cinemas RGC and selling short an equal dollar amount of Speedway Motorsports TRK. For guidance, I called one of the smartest pair traders I know. His response was, “Don't do it!” “Why?” I asked. “Because correlations are as high as they have been since 1987,” he replied. Further research reveals that he's right, for arguably the best pair trading hedge fund in the business is down 11% year to date. Here's why. The chart on page 3 shows the correlation of S&P 500 stocks to the S&P 500 Index. Studying the chart one finds that the correlation from September 2009 through early May 2010 ranged between 55 – 65. However, following the May 6th “flash crash” the correlation leaps to ~78 and eventually ~82, which is indeed the highest correlation since the 1987 crash. So what caused this fairly rare event? In my opinion it is because the retail investor – disgusted with high-frequency trading, dark pools, trading huddles, inter-market sweep orders, etc. – simply left the game, leaving the “pros” to trade among themselves. Obviously, when the alleged “dumb money” left the party correlation had to rise. Adding to the situation has been Exchange-Traded Funds (ETFs). To wit, when volume increases in say the Powershares Consumer Discretionary ETF PEZ, that ETF automatically goes in and buys ALL 60 of the mid-cap stocks within the fund. Plainly, that causes correlation to rise. Read the rest here.