Determined to follow my pairs trade plan

KC Capital MgmtAuthor: Beau Wolinsky, KC Capital Management

Covestor model: Quantitative ETF

Disclosures: None

Our Quantitative ETF model was up 2.18% in November, while the S&P 500 fell 0.51% and the benchmark Dow Jones U.S. Moderate Index fell 0.51%.

We essentially did nothing in the month but exit three positions. We waited for wash sale rules and the possibility of reaching an overbought level that we find attractive enough to go short via a long on SQQQ, a 3x leveraged short instrument.

We’ve found that some of our backtesting assumptions were invalid, as we overestimated our run-up and profitability. Going into this month we’ve breached through higher highs (essentially in the last two days of the month), and I’ve got to say this looks like a very obvious overbought level. We believe this breach is both a higher high and a lower high.

The European debt crisis which caused us to enter at an unfavorable level long does not appear to be reaching resolution, and even if the Fed is willing to extend their credit lines to the ECB this will undoubtedly put selling pressure on the dollar, leading to hyperinflation, and generally to more price rises in consumer goods and commodities.

The Black Friday sales came in above expectations, and I think the market is trying to determine if retailers actually have pricing power. In the next few months there will be a series of sales and promotions and this will make or break many retailers. When it comes to Apple (AAPL), we think that the stock is a good bet to $500, but we trade ETFs and that is a stock that will prevent too much selling pressure.

This is a month where I am determined to follow my plan for my pairs trades. Due to seasonality, however, there is a high likelihood that our short will not succeed, even though the chart looks ripe for shorting after what must have been a lot of short covering November 30th.

I’ve determined that just as we had the worst October since 1932 this year, we could see a very nasty selloff here, and if you are long, you should consider hedging long/short positions. I believe our markets are not doing well, even if the data says so.

Even though it was my goal last month to get into the black, we haven’t had any opportunities because the market was selling off nearly every single trading day except for the last one. As of the first of December we think one can legitimately sell their stock positions, keep bonds with 2-3 year maturities and no more than 5 year durations. These are only guidelines, but I think they agree with the anticipation of rising interest rates next year very well.

We aren’t out of the woods yet, and if the Fed thinks the ECB should get a bazooka like we used in 2008, I’m sure this rampant chaos in Eurozone debt markets could work itself out. You can’t keep borrowing money to pay promises you couldn’t afford to pay or ever pay, just as Greece, Italy, Spain, and Portugal have found making socialist promises does not help promote fiscal responsibility.

I’m sure the ECB knows well from what it saw the Fed doing in 2008 that something on that order of magnitude well into the trillions of Euros is required to save European Markets from inevitable collapse lead by the Euro falling sharply, possibly even reaching parity with the dollar. I’m thinking the next hat to drop could be more downgrades and state bankruptcies.

Within the next year we’ll be facing the choices of the budgetary super committee and seeing what they’d like to cut out of our sacred commitments to the American public, which has paid into social security with little chance of ever seeing what they’ve paid returned back to them.

How this affects me has more to do with where we are on the index charts. As of this moment we think the market is overbought, especially after the last day of November.

Merry Christmas and a Happy New Year to you all.