Why you should ignore the market

Have the courage to be neutral

The markets are currently reacting extremely sensitively to news flow, hanging feverishly on announcements from politicians. Since the beginning of the year, the European markets have been on a veritable rollercoaster ride and there still appears to be no effective resolution in sight that would bring a lasting economic recovery. The swings have been pronounced: up 4 per cent today, down 4 per cent tomorrow – this pattern was repeated regularly in August and September.

Deliberately ignore the market

In an environment where the day-to-day mood of market participants can see the markets run amok, there is one option that presents itself: ignore the market. This can be done, for example, with a market and sector-neutral investment strategy aimed at seizing opportunities irrespective of the prevailing trend on the markets.

There are various approaches that can be used to achieve this. One method is the long/short pairs trading approach, where individual stocks are strategically combined in pairs.

With this approach, the investor seeks out two companies that they expect are likely to perform differently. In the case of the company with the better prospects, the investor goes “long” – that is to say, takes up a buying position. With the other company, the investor goes “short”, or takes up a selling position. If the long position outperforms the short position, the investor gains. The interesting thing here is that the strategy doesn’t only work if the more attractive stock rises and the other falls. Even if both were to decline, the pairing can be profitable as long as the long stock falls less than the short one. What is important is to have two stocks from the same sector that are equally weighted when the initial investment is made. This is the only way to ensure that the investment is not only market-neutral but sector-neutral as well.

Searching for the “best” and “worst” stocks

The choice of the equity pairs is crucial, selection calls for experience and discipline. Investors should ask what sets a healthy company apart from one that is not in such good shape. The criteria should include both quantitative and qualitative data. When forming a portfolio you have to ensure that the pairs do not react in sync to market developments, as this is the only way to prevent clusters of risk in the portfolio.

Let us take a specific example of a long-short equity pair to illustrate the principle. In the utilities sector, for example, the Spanish firm Red Electrica and the German company E.ON would have been a profitable pair from March 2011. Red Electrica is the comparatively “better” stock relative to E.ON, as it boasts high operating margins and is enjoying above-average growth in both revenues and earnings compared with the sector.

In the case of E.ON, however, the cost of capital is higher than the cash-flow return – the company is thus effectively eroding shareholder value. In addition to this, E.ON had to lower its dividend in 2011, and its operations are very capital-intensive. Even on the basis of these criteria alone, Red Electrica is a candidate for a buying position and E.ON for the corresponding selling position.

Stock market performance since March 2011 shows that both share prices have fallen, although the Spanish stock lost 11 per cent while its German counterpart fell 31 per cent. For a market-neutral investor, this is an excellent result: the difference between the two share prices – namely some 20 per cent – is credited to their account, and this in an extremely difficult market environment.

With smart portfolio structuring and effective risk management, the fluctuations in value for a market-neutral strategy are much lower than on the stock markets. Particularly in the current environment, where investors are seeking to reduce risks, this is yet another reason to deliberately ignore the market.