A pair trade strategy refinement to consider to take advantage of long term market psychology which is known to persist despite evidence that the market is changing.
I was thinking of a pair trade earlier today that would capture something like the mood of the mass market psychology in practice. It would pit the wisdom and maturity of the world's greatest value investor against the promise of opportunity of the most volatile marketers. Specifically, this pair trade would feature Warren Buffett vs emerging markets. The symbols involved would be: BRK/B for Warren Buffett's Berkshire Hathaway Class b shares and symbol EEM representing the emerging markets exchange traded fund (ETF). Clearly, this is a pure volatility or market psychology play.
The concept: EEM should outperform Buffett whenever market mob psychology is insanely overvaluing growth at the expense of real earnings. Buffett should outperform when we begin to see whiffs of fear entering the markets and we experience a flight to quality.
In good times then we would want to be long EEM and short BRK/B in order to capture the difference in relative strength. We'd be long enthusiasm and short wisdom, which is a pretty good definition of market mob psychology in extreme bull markets.
In bad times we would reverse the strategy and be long Buffett and short emerging markets. I am going to run some research tests on this going back a decade, but my intuition suggests that this will be a fruitful idea. We have to be sensitive to when market conditions change in any pair trade, but in this case a simple moving average crossover should be sufficient to protect against disaster.
As always, do your own due diligence and consult a financial professional before taking actions, as the stock market is inherently risky.
Ken Long, Chief of Research, Tortoise Capital Management Independent research, combining technical analysis and behavioral psychology. |
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