METV - 2024 Pairs Trade: Long Tech Vs. Short Financials

2023-12-18 23:07:26 ET

Summary

• Pairs trading strategy of long technology and short financials could be beneficial for investors in 2024.
• The strategy allows investors to maintain a bullish position in technology while implementing a bearish position in financials.
• The recent performance of the technology sector and the potential for a market correction make the pairs trade attractive.

By Andrew Prochnow

For those exploring fresh investment and trading strategies for 2024, considering the long technology versus short financials pairs trade could be worthwhile. This approach may be particularly advantageous for individuals who are already positioned on the long side of the technology sector, either through individual stocks or ETFs.

Pairs trades offer a distinctive advantage by allowing investors and traders to maintain a preferred bullish position, such as in technology, while simultaneously implementing a bearish position in a sector or product with a less optimistic outlook, such as financials.

And with the new trading year on the horizon, now is a great time to consider portfolio positioning , especially with the major market indices recently stretching toward fresh all-time highs.

The purpose of a pairs trade is to capitalize on the collective movement of the two positions, resulting in various outcomes. This could entail a substantial profit in one position alongside a minor loss in the other, or it might involve smaller profits from both positions.

In the current landscape of 2023, it has predominantly been the former scenario, where the long tech trade has generated substantial profits, and the short financials trade has incurred a modest loss, which, in many respects, is considered an ideal outcome.

For instance, the Technology Select Sector SPDR Fund ( XLK ) has seen a remarkable 55% increase in value in 2023, while the Financial Select Sector SPDR Fund ( XLF ) has only risen by 9%. Consequently, the long position in XLK has yielded a substantial gain, whereas the short position in XLF has resulted in a minor loss. This holds true whether the pairs trade was structured in a 1:1 ratio or a 1:4 ratio. The latter structure would be suitable for those aiming to balance the trade proportionally, as, at the beginning of the year, shares of XLK were approximately four times more valuable than shares of XLF.

XLK started the year trading at roughly $123/share and has since risen to a value of about $191/share. That means an investor who bought 1,000 shares of XLK in early January has made a profit of about $68,000 to date.

On the other hand, XLF started the year trading at roughly $34.32/share and is currently trading at $37.35/share. That means shorting 1,000 shares of XLF would have resulted in a loss of around $3,000 while shorting 4,000 shares would have resulted in a loss of around $12,000.

Therefore, the net result of the XLK-XLF pairs trade - executed in 1:1 fashion - has been a $65,000 profit ($68,000 - $3,000 = $65,000). Alternatively, the same pairs trade structured in a 1:4 fashion (to better balance the delta exposure of the trade)-has produced $56,000 in profit ($68,000 - $12,000 = $56,000).

Why the XLK-XLF Pair Still Looks Attractive Heading into 2024

Looking ahead into 2024, the XLK-XLF pairs trade still looks attractive, especially for those investors who are already long in the tech sector.

This structure looks attractive not only because of the respective outlooks for each market sector but also because the major market indices recently climbed toward fresh all-time highs.

Pairs trades work most efficiently when the two underlying share a strong positive correlation. Over the last two months, XLK and XLK have exhibited a positive correlation of roughly 0.63.

A strong positive correlation is important with a pairs trade, because it helps insulate the combined position from the risk of a broad-based market correction. If the market corrects, both underlying should move lower, providing the investor/trader some degree of protection from the short leg of the trade.

And that scenario also helps illustrate why a pairs trade arguably becomes more attractive when the market is trending toward all-time highs. As of right now, tech stocks remain attractive due to ongoing strength in their associated fundamentals. So far this year, profits in the tech sector have been robust, especially at the top of the food chain.

For example, the average profit margin for the "Magnificent Seven" has been roughly 19% in 2023, while the average profit margin for the other 493 stocks in the S&P 500 has been closer to 10%.

Looking at a sector breakdown, one can see in the chart below that the tech sector produced a profit margin over 22% in Q2, while the financial sector has produced a profit margin of roughly 16% - both of which are comparable to their respective 5-year averages.

Not surprisingly, the tech sector's ability to produce stronger profits has also translated to higher valuation multiples.

These days, the forward price/earnings (P/E) for the tech sector is roughly 26, while the forward price/earnings for the financial sector is about 15. Both of those figures represent a premium with respect to the 5-year averages. For the tech sector, the 5-year average is closer to 23, and for the financial sector, it's closer to 13.

From this perspective, one could argue that both sectors are slightly overvalued, which probably isn't a big surprise given that the major indices are sitting near record highs. That said, the forward price/earnings for the overall S&P 500 is hovering around 19, which is below its recent peak of 22.

The forward price/earnings ratio provides investors with the opportunity to assess an investment's market price in relation to the anticipated earnings it is expected to generate. To illustrate, a 19x forward earnings ratio indicates that it would take 19 years for the S&P 500 index to generate income equivalent to its present market capitalization.

Considering the provided information, the overall S&P 500 does not seem inherently overvalued presently, even though it is trading close to its all-time highs.

Long Tech vs. Short Financials: Additional Considerations

With the major market indices trending toward fresh all-time highs, there's an argument to be made that investors and traders would be prudent to trim long equities exposure at this time.

Alternatively, investors and traders could initiate a new bearish position in their portfolios to help offset existing long exposure. One way to do so would be to pair an existing long tech position with a short position in the financials.

A position such as this arguably provides additional protection from the risk of a correction in the financial markets, especially for investors and traders who were planning to hold onto their long tech positions. With this pair in place, the short financials component of the trade theoretically provides additional insurance in the event of broad-based market selloff.

On the other hand, if the stock market continues to rally, it's virtually assured that the tech sector will continue to outperform the financials, as it has done for some time. Over the last five years, the XLK is up about 223%, while the XLF is up closer to 63%.

And as of late 2023, the tech sector continues to shine, while the financial sector faces a significant "wall of worry." As most are well aware, the financial industry was besieged by a regional banking crisis earlier in the year. And some have recently argued that the worst may still be yet to come.

On top of that, U.S. financial institutions are sitting on a mountain of unrealized losses.

Recently, the Federal Deposit Insurance Corporation (FDIC) estimated that total unrealized losses at FDIC-insured banks had risen to nearly $700 billion. Those losses represent the difference between what these institutions paid for their holdings of government bonds as compared to the current market prices of those bonds, as highlighted below.

Additionally, a recent analysis indicated that profit margins in the financial industry could come under pressure in 2024, which further detracts from the relative attractiveness of the sector. In contrast, revenues and earnings in the tech sector are projected to strengthen next year.

Taking all factors into account, investors and traders aiming to capitalize on potential gains in the tech sector may consider coupling that optimistic outlook with a short position in the financials. This strategy proved highly successful in 2023, and given current data and sentiment, it holds promise for favorable outcomes in 2024.

In this specific trade configuration, the most unfavorable outcome would be if financials were to outperform tech stocks. However, given the historical 5-year returns in each sector, this seems like a relatively remote possibility.

Conversely, in the event of a market correction, the short financials trade could help mitigate losses incurred from the long tech trade. This scenario gains significance as the major market indices currently linger near their all-time highs.

Overall, the risk-reward dynamics of the long tech versus short financial pairs trade seem favorable at present. For those new to pairs trading, engaging in a "mock trade" (i.e., paper trading) can provide a valuable opportunity to understand the behavior of this strategy without risking actual capital losses.

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