A Unique Strategy to Play Offense and Defense in This Market

Heading into last week’s election and the Federal Reserve’s latest stimulus efforts, the stock market looked set to pause. After all, the major indices had been in rally mode since late August and bargain prices were harder to find. Yet the market rallied even further late last week, returning stocks to pre-Lehman crisis levels. But this is no time to be complacent: even as the market looks healthy, it could just as easily falter at this point as earnings season winds down and market-moving catalysts don’t appear on the near-term radar.

Rather than try to bet on the market’s direction, you’re better off focusing on specific investment plays. And even as you stand by your bullish picks, it makes sense to offset them with equally bearish picks. This “market neutral” approach, known as paired trading, should do well regardless of which way the broader stock market goes.

In a paired trade (called by some a “pair trade”), you go long with a stock in a certain industry and make a corresponding short investment on an industry peer that looks less attractive. For example, you may like the prospects for steel maker Nucor (NYSE: NUE) but are concerned about the broader economy and its impact on steel stocks. So you could short rival U.S. Steel (NYSE: X) if you thought that it would not benefit as much in a scenario of a recovering economy.

With that in mind, here are three current pair trades that I like:

1. AMR (long) vs. UAL (short)
The challenge of paired trades is not simply to find a company that is operating at peak levels and correspondingly bet against companies that are performing weakly. Instead, you want to gauge where those companies may be in the next 12 to 24 months, and how their shares are currently valued. In that context, AMR (NYSE: AMR), which is currently an airline industry laggard, and United Continental (NUSE: UAL), which is reaping the benefits of a solid merger, are a play on reversing fortunes.

United Continental is posting great numbers right now — revenue at each of the two airlines jumped sharply in October — and analysts have been talking up shares based on the myriad synergies that the merger will yield. As a result, shares have tripled in the last year — reflecting all of the income statement gains yet to come.

Meanwhile, AMR has been struggling with high labor and pension costs, and stubborn operating losses, and has only recently joined the airline sector rally. But looking ahead, it may be AMR’s turn to shine.

For starters, AMR has a high degree of exposure to the North America-South America travel market, which is expected to be characterized by restrained supply growth but rising demand in 2011. Carriers like AMR tend to operate international flights much more profitably than domestic flights, and booming economies in Brazil, Colombia and Chile should allow this region to be highly profitable for AMR.

Second, AMR has spent much of 2010 focusing on shoring up its underfunded pensions and upgrading its aging fleet. Those expenses are expected to be sharply lower in 2011, which should help free cash flow (FCF) to soar. Barclays estimates that AMR could generate $750 million in FCF next year, yet the company’s stock is valued at less than $3 billion, equating to a FCF yield of around 25%. According to Barclay’s that’s the highest in the sector.

Much of this call resides on external conditions such as demand for air travel and oil prices. Those factors may help or hurt in 2011. By focusing on a pair trade, you can remove these possible factors and stock market risk.

2. NuVasive (long) vs. Intuitive Surgical (short)
In the past two decades, surgeons have seen a revolution in terms of spinal surgery. Thanks to companies like Intuitive Surgical (Nasdaq: ISRG), patients now have a much better chance of exiting the operating room with a hoped-for end to chronic back pain and disability. In recent years, industry upstart NuVasive (Nasdaq; NUVA) has also appeared on the scene with a set of surgical tools that set a new benchmark for minimally invasive spinal surgeries that yield faster recoveries. The company’s sales surged from $50 million in 2004 to nearly $500 million this year. Management has laid out plans to fuel further growth by training more doctors in the United States on its platform of tools and expanding internationally.

At least here in the U.S., those growth plans may have to slow a bit in the near-term as the company recently warned that the changing healthcare landscape is leading many patients to defer elective surgery. To be sure, NuVasive’s approach represents real cost-savings for health care insurers thanks to improved patient outcomes and shorter hospital stays. Shares of NuVasive have fallen -45% from their 52-week high on concerns that sales growth will slow to +10% to +15% next year. Yet if that’s the case, then forecasts that rival Intuitive Surgical will boost sales nearly +20% next year looks too optimistic.

So by my math, shares of NuVasive will rebound nicely if near-term growth concerns prove overblown. Or shares of Intuitive Surgical have ample room to fall if NuVasive’s cautious view comes to pass. This pair trade removes the element of risk associated with forecasting sales trends in the spinal surgery market.

3. Christopher & Banks (long) vs. Liz Claiborne (short)
Spending on women’s apparel remains in a funk thanks to the weak economy. And weak spending has been especially painful for Christopher & Banks (NYSE: CBK), which recently had to change leadership after seeing shares fall from $30 in late 2006 to a recent $6. But this retailer still has strong resonance with its customer base, and should see nice gains once the economy improves. Sales growth is likely to be just +2% to +3% next year, to around $475 million. But I look for sales to rebound +5% to +10% in 2012, which should fuel EPS growth at a much faster pace. A return to a $10 or $15 share price is not out of the question in such a rebound scenario.

Conversely, if the economy remains weak, then shares of Liz Claiborne (NYSE: LIZ) look increasingly vulnerable. Its shares have risen +50% since late August. Those gains have partially come from a recent rebound in gross margins, yet cotton prices have risen sharply in recent days and analysts’ forecasts of Liz Claiborne’s profit levels may need to come down.

If the economy rebounds, Christopher & Banks looks to have major profit leverage. Yet if the economy doesn’t rebound and rising cotton prices start to bite, the recent strong rebound for Liz makes that stock risky.

Action to Take –> Since we lack a crystal ball, immunizing your portfolio against bull or bear markets can be a prudent approach. AMR, NuVasive and Christopher & Banks look cheaper than their peers on a variety of metrics. They have more upside in a bull market, and likely less downside in a falling market. By pairing these stocks with their bearish counterparts, you can significantly reduce downside risk, while still enjoying the upside.

P.S. — Any analyst can tell you they like a stock. But how many are willing to put their money where their mouth is? StreetAuthority Market Advisor is so confident in Nathan Slaughter’s picks that we gave him $100,000 in cash to put into his recommendations. Learn how you can join in and profit along with him.