Pairs Trading Can Be Risky!

So, I thought I’d check up on a pairs trade that I was considering entering last March. Pairs trading involves taking advantage of a correlation between two markets or stocks. When the pairs diverge, you short the higher one and buy the lower one, hoping that they will come back together in the future, and you will capture the difference as profit.

I noted one such divergence between the oil market and the clean energy sector. They usually are highly correlated because higher oil prices makes investment in alternative energy technologies more attractive. Early last year, as oil went on its historic bull run, the correlation broke down. I saw an opportunity for a pairs trade emerge. The chart below shows the divergence:

(from Yahoo Finance)

I have to say I’m not exactly sure why I did not take on the position. Anyhow, I did not, and it was probably a good thing. The blue dot on the graph is when I would have put on the position. I would have been short USO, the graph on top, and long PBW, the graph on bottom. As of about July 1st, I would have been carrying about a 40% loss on USO, and about a 20% loss on PBW!!! Ouch! Even with a leverage of 2-to-1, I would have stopped out! With out leverage, I would have had to wait until December to realize a loss of about 60% on PBW and a gain of about 80% on USO, for a net of about 20%.

Looking deeper into the pair, the correlation coefficient is 0.49, which is quite a bit lower than the 0.70 that some people consider a minimum for a significant correlation. However, I like the logical argument behind the correlation and attribute the low coefficient to my small data set that only goes back to 2006.

The point of this article is that, sometimes, markets can irrationally diverge for longer than you can stay solvent. Even a hedged pairs trade can be very risky under leverage. But, if you’re careful and patient, you can make money in a logical way!

GDP Growth? Or Not?

The way that GDP is reported by our government always frustrated me. The calculation of GDP includes government spending. What this means is that it's possible for the government to borrow money and "create" GDP out of thin air. This is why fiscal policy is so important to the economy.

So, does the government influence GDP with fiscal policy? Of course. I'd like to focus on the most recent Bush administration. During the last 8 years, the economy grew at a small but pretty even rate. However, at the same time, we ran record deficits. So, did the Bush administration create a growing GDP by borrowing money on the US taxpayer's good name?

The graph above shows 3 lines. The blue line is the official reported GDP adjusted for inflation. The red line is the government account deficit/surplus. If the red line is above zero, then the government ran a surplus. If the red line is below zero, the government ran a deficit. The green line is GDP minus the government account deficit.

Note that when the government runs a deficit, corrected GDP is lower than reported GDP, because the government is borrowing money to stimulate the economy. When the government runs a surplus, the corrected GDP is higher, because the government is taking money out of the economy, via taxes, and paying off government debt instead of stimulating the economy.

There are some interesting things to note. During the late nineties, the economy was roaring on its own, as much as seven percent, while fiscal policy was paying off government debt. This would tend to show the Clinton years as stronger economically than some would like to admit. During the first and second Bush administrations, the government tended to borrow enough money to keep GDP positive. This leads me to believe that the economy grew very little on its own during the Bush administrations.

I should hope that Obama can learn from what is shown here, and implement sound economic policies that grow the economy, rather than deficit spending to cover up a bad GDP.