Know When to Fold 'Em
Country singer Kenny Rogers has been called many things. Somehow I do not think stock trader is among them. However, some of the famous lines from his songs can be applied to investing. While selecting stocks and deciding what to buy is extremely important, knowing "when to fold them" is just as important.
A key premise that distinguishes me from other professional investors, which I have employed to my advantage in the time I have been writing my weekly newsletter EPIC Insights, is that the discipline to sell stocks is extremely important. Many have been so hammered by the dogma of buy-and-hold investing that they never think when the proper time to exit a position is. By constantly assessing and measuring the risk of our portfolio, I have built a track record that clearly shows that adhering to a specific sell discipline is just as important in creating long-term wealth as is deciding what to buy at what time.
When it comes to selling a portfolio position, deciding when to exit is usually easy. If the stock was bought because it was trading below fair value, once fair value is reached, I sell. If the transaction was based on technical patterns, once those patterns have either completed or reversed, I exit. However, turn to another type of trade, a pair trade, and the decision is more opaque.
A pair trade involves two securities that are affected by similar events and tend to trade in tandem. When the typical relationship between the items no longer holds, we have an opportunity to buy one item, sell the other, and allow mean reversion to restore the typical relationship.
Since broad market factors are eliminated by offsetting long and short, pair trades work well in markets that are range bound. However, when prices run dramatically in either direction, much like the situation we now face, pairs are less effective.
Looking at our current portfolio we have three pair trades-long Goldman Sachs (GS) versus short Morgan Stanley (MS), long gold (GLD) versus short oil (USO), and long UAL (UAUA) versus short Continental (CAL). Although each of these trades was constructed for different reasons, they all have one common trait in that they have delivered profits to our portfolio.
To review, I recommended buying GS and shorting MS when financial stocks were weak because I felt GS possessed a better business strategy, culture, and management. Since then, all financial stocks have been red hot with our shares in GS increasing 53% and the short MS position moving higher 45%. Clearly, being long of banks would have been a better trade, but any time you can earn 8% in a purely hedged fashion is respectable.
I recommended buying UAUA and shorting CAL when CAL traded at a 210% price premium to UAUA. I felt the number would drop closer to 185% and the premium currently rests at 188%. By correctly calling for the price reversion, we earned 15% from this hedged trade.
Finally, inflationary pressures, an uncertain economic recovery, and oil being expensive relative to gold all called for us to buy gold and short oil. In less than a month, gold has risen above $1,000 and this trade has returned a 5% profit.
Having seen these gains delivered, I am channeling Kenny Rogers and know that I should fold them. With the market moving relentlessly higher, hedged pair trades will not operate as expected. Further, having seen mean reversion deliver us gains, I see no need to risk our profits. Taking gains has treated us well in the past and I expect it to continue doing so in the future. I recommend selling GS, GLD, and UAUA and buying-to-cover MS, USO, and CAL as this week's fundamental trade.
The preceding article is from one of our external contributors. It does not represent the opinion of Benzinga and has not been edited.
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