Is Attacq the best form of defence?

Going long on resources and short on listed property with a relative pair

C aution has been the name of game for the past few months. In late 2018 we started seeing signs that the record long bull market might be coming to an end, and recently — from a technical analysis perspective at least — we saw international markets moving into a bear phase.

This changes how we need to approach the markets, at least from a short- to mediumterm perspective. A cautious and conservative approach should be adopted.

But we have to balance the need for caution with the obligation to take risk, to generate returns. This is where relative plays become useful.

Last month we traded a relative pair in a sector that has been outperforming the overall market. We traded a short position on FirstRand and a long position on Absa because on a relative basis Absa is outperforming FirstRand, while both stocks are in a sector that, at the time, was outperforming the top 40 index.

Since then there have been some changes. The rand has weakened substantially and the financial 15 index has become an underperforming sector compared to the overall market index, the top 40.

Even so, I expect Absa to continue to outperform FirstRand for some time.

In the meantime, this creates new opportunities.

As the “risk-off” sentiment proliferates through global and local markets, the flow of investment funds follows suit.

Thus, in recent weeks the rand lost ground against major currencies and the relative performance of various sectors versus the top 40 index changed. With the objective of balancing our need to be cautious with our requirement to take risk, the hunt is on for sectors where we can take risk and remove risk from our portfolios.

Studying underlying market strength reveals a few things.

The first is that platinum mining has moved into first place as the best-performing sector on the JSE.

The second is that of the 54 sectors studied, only 12 are outperforming the top 40 index, while four are performing in line with the index and 38 are underperforming the top 40. This means that sectoral relative market breadth is 31.5%, or, to put it more plainly, 68.5% of the market is underperforming the benchmark index.

Considering that overall market return over the past three years is negative and that the majority of the market is underperforming an already negative benchmark, the need for caution becomes clear.

How do we position ourselves to generate return while avoiding excessive risk?

The game plan is similar to what it was last month — a pair trade, but this time between sectors instead of two individual stocks in one sector.

In an ideal world we would be able to go long on the platinum mining sector and short on the oil and gas sector. It’s a trade you could likely do with the use of various index futures, but in practical terms these instruments are not very liquid and most investors do not have the access or the know-how to be able to trade them.

We will have to settle for second best then and make use of the available exchange traded funds (ETFs) listed on the JSE. (Second best in this case does not mean it’s not a good trade.)

The weakest-performing index with a tradeable ETF is the SA listed property index (Sapy), with the CoreShares PropTrax Sapy ETF. The strongest-performing index with a tradeable ETF is the resource index, with the Satrix RESI ETF.

Once again we lean on the use of derivatives to enter a short position, using a contract for difference (CFD), on the PropTrax Sapy ETF.

The other leg of this trade is to take a long position in the Satrix RESI ETF, by either buying the normal equity or by making use of a CFD.

It is crucial that the nominal exposure, or value of, each leg of the trade (long and short) are equal to each other. Exact equal values in opposite directions at the onset of this trade will ensure two things: first, the total nominal risk exposure is equal to zero, meaning it is a low-risk trade; and, second, as the two sectors continue to diverge in performance — mining and resources keeps performing well while listed property keeps performing poorly — the two sectors will diverge and the trade will generate a profit.

Considering that overall market return over the past three years is negative and the majority of the market is underperforming an already negative benchmark, the need for caution becomes clear It is crucial that the nominal exposure, or value of, each leg of the trade (long and short) are equal to each other