Pairs Trading the Consumer: Long WMT – Short JWN

Part of our job at Invest With An Edge is to give you some useful investing ideas you may not hear about on CNBC or see online.  Whether we repeat trading mantras like the “January Effect” or discuss more obscure tactics, we aim to educate.

Today we will review a method many sophisticated investors employ in certain circumstances: pairs trading.  Pairs trading involves buying one asset and selling short another (usually correlated) asset.  The gain or loss is realized in the difference between the two trades. 

For instance, you might consider buying Apple (AAPL) and shorting Microsoft (MSFT).  In this trade, you would make money if Apple goes up more than Microsoft goes up OR if Apple goes down less than Microsoft goes down.  Even if both stocks go down, you could still make money from the trade – as long as AAPL declines less than MSFT.

Pairs trading is a useful method when you’re not sure what the market’s doing.  Will the market continue to rally?  Maybe.  Will it test the lows again?  It’s not out of the question.  Let’s assume a couple of things.  First, we’re in for more general economic weakness in the coming months.   Second, consumer staples stocks tend to do better than consumer discretionary stocks in recessions and bear markets.

How to trade this?  Consider a pairs trade in “the consumer” by going long staples and short discretionary.  The best-known consumer staples stock is Wal-Mart (WMT).  In the past 52 weeks, Wal-Mart has fallen much less than most other consumer staples stocks – losing just -1.1%.  In a market that’s down over -40% in the past year, these returns are outstanding.  The reason is obvious: no matter what happens in the economy, people still need groceries, toilet paper, and all kinds of other everyday goods.  Wal-Mart is the largest supplier of consumer goods in the country because their pricing and accessibility surpasses their rivals.

However, consumer discretionary and luxury goods have not fared as well.  According to Forbes, luxury retailers aren’t ready to recover soon.  One of the flagship discretionary retailers is Nordstrom (JWN).  In the past 12 months, JWN has lost nearly -54%.  Consumers may still need toilet paper, but they don’t want $90 ties wrapped in tissue paper.  Consequently, the Street has punished the stock.  Despite Obama’s new assurances, most consumers still aren’t ready to pay Nordstrom’s cover charge.

We think you can continue to profit on the difference between Wal-Mart and Nordstrom.  Wal-Mart may decline, but if you’re hedged with Nordstrom, you’re in a safer place.  JWN has rallied over 125% from its recent lows, and it can’t seem to navigate heavy resistance in the $16 area.  In addition, the recent rally seems unconvincing with low trading volume.  If the economic storm clouds fail to clear, JWN could easily sink back into the single digits. 

To pairs trade WMT and JWN, you want to buy WMT and sell short the same dollar amount of JWN.  For instance, for every $1000 you buy of WMT, short-sell $1000 of JWN.  Again, you’re just looking to profit from the relative difference between the two securities.  Both stocks could decline, and you could still make money.  Keep in mind that if you exit one side of the trade before the other, your hedge will be gone and you’ll then be fully long or short. 

To profit from weak consumer discretionary and stable consumer staples, buy WMT and short JWN.