I also took outright positions in large-cap stocks by buying the 10 worst performers in the S&P 500 at the end of September ('Make 17% in 90 Days', 30 Sep 2011) to capitalise on a likely rebound in the index from a heavily oversold position. The strategy paid off spectacularly and I was fortunate to cash in four weeks later and bank a 22 per cent gain. And a more speculative investment in three high-beta shares – Barclays, Essar Energy and Xstrata – all produced high-beta returns when the market bounced back in the autumn ('Beta blockers', 12 Oct 2011). In fact, in little over two weeks we made a 19 per cent gain on those three short-term trades.
Since then I have been quietly biding my time waiting to put on another trade to play the market volatility and the seasonal factors that come into play in the first quarter of each year. That's because the trading strategy I have in mind has an unbelievable track record of repeating itself year in year out and has done so for the best part of three decades. More importantly, those in the know have made bumper returns by following this trade.
Housebuilders' first-quarter effect
Here's how it works: in the first week of the year all you have to do is pair trade the housebuilding sector against the UK market by buying shares in the seven FTSE 250 listed housebuilders – Barratt Developments, Bellway, Berkeley, Bovis, Redrow, Persimmon and Taylor Wimpey – and simultaneously short-selling the market over the first quarter.
Since 1980, if you had bought a selection of shares in the housebuilders at the start of January and simultaneously sold short the same value of UK stock market, this trade would have produced a positive return during the first quarter in no fewer than 27 of the past 32 years. The average return from this long-short trading strategy has been an impressive 7.3 per cent. And remember this strategy not only improves the chances of generating a positive return during the first quarter, it also reduces risk.
That's important this year because we could be in for further market turmoil in the months ahead, so we really don't want to be holding too many long positions without having a hedge in place to guard against a fall in the market.
Table one: Housebuilders' first-quarter performance since 1980
| Year | Housebuilding sector quarterly return (%) | FTSE All-Share quarterly return (%) | Pair trade net return (%) |
| 1980 | 6.6 | 4.6 | 2.0 |
| 1981 | 53.5 | 6.0 | 47.5 |
| 1982 | 18.0 | 4.3 | 13.7 |
| 1983 | 15.9 | 7.8 | 8.1 |
| 1984 | 4.9 | 11.4 | -6.5 |
| 1985 | -10.7 | 3.9 | -14.6 |
| 1986 | 30.1 | 18.7 | 11.4 |
| 1987 | 25.6 | 20.2 | 5.4 |
| 1988 | 10.9 | 3.0 | 7.9 |
| 1989 | 16.8 | 16.1 | 0.7 |
| 1990 | -7.0 | -7.4 | 0.4 |
| 1991 | 18.6 | 15.6 | 3.0 |
| 1992 | 7.5 | -1.4 | 8.9 |
| 1993 | 13.3 | 3.2 | 10.1 |
| 1994 | -4.0 | -7.1 | 3.1 |
| 1995 | 2.7 | 1.1 | 1.6 |
| 1996 | 5.1 | 2.2 | 2.9 |
| 1997 | 5.9 | 4.3 | 1.6 |
| 1998 | 21.5 | 15.4 | 6.1 |
| 1999 | 34.5 | 8.3 | 26.2 |
| 2000 | -16.2 | -4.1 | -12.1 |
| 2001 | 14.8 | -9.1 | 23.9 |
| 2002 | 12.0 | 1.3 | 10.7 |
| 2003 | 0.4 | -8.3 | 8.7 |
| 2004 | 19.0 | -0.5 | 19.5 |
| 2005 | 8.1 | 1.7 | 6.4 |
| 2006 | 8.3 | 7.1 | 1.2 |
| 2007 | 0.1 | 1.9 | -1.8 |
| 2008 | -6.5 | -10.9 | 4.4 |
| 2009 | 16.4 | -10.2 | 26.6 |
| 2010 | 0.5 | 2.8 | -3.3 |
| 2011 | 12.7 | 0.8 | 10.9 |
| Quarterly return | 10.6 | 3.2 | 7.3 |
| Up years | 27 | 23 | 27 |
| Down years | 5 | 9 | 5 |
| Source: Trading Secrets, 20 Hard and fast ways to beat the stock market, FT Prentice Hall, Simon Thompson | |||
Reducing investment risk
Granted, the 7.3 per cent net quarterly return following my pair-trade strategy is less than the 10.6 per cent average return made by simply buying a selection of the UK's housebuilders at the start of January. However, a quick glance at the results in 2008 and 2009 illustrates why this long-short trading strategy has its merits. To recap, the UK stock market fell off a cliff in the first three months of those years, ending the quarter down over 10 per cent. But even in the face of a savage sell-off across global equity markets, a strategy of buying the housebuilders and short-selling the market produced a positive net return of 4.4 per cent and 26.6 per cent, respectively, in the first quarter of 2008 and 2009.
Risk aversion
These recent experiences highlight the risk-averse nature of this long-short trade. Namely, if markets are rising – as they traditionally do during the seasonally strong winter months – then, given the even stronger seasonal bias of the housebuilding sector, the odds are heavily skewed towards the sector outperforming the market as a whole. However, if markets are falling in the first quarter – as they have done during nine of the past 30 years – then the housebuilding sector is far less likely to fall with the market. In fact, there are five years – 1992, 2001, 2003, 2004 and 2009 – when the UK stock market fell in the first quarter, but the housebuilding sector still produced a positive return. In these instances, investors would have made gains on both sides of the pair trade.
Reasons for the phenomenon
Housebuilding is a highly seasonal business with newsflow and sales firmly skewed towards the all-important spring selling season. So at this time of year there is increased investor interest in housebuilders as investors focus on price trends and the strength of the underlying housing market. And as these companies report financial results and issue trading statements in the first quarter – the majority have calendar or January year-ends – this focuses investor attention on the merits of the sector. There is also another reason why the sector outperforms the general market in the first quarter: this time of the year is when investing in 'value' stocks does well.
Without any doubt housebuilders are value plays as most trade on deep discounts to net asset value – the majority of which is tied up in valuable land banks that are being turned into cash. In turn, this means that balance sheet gearing levels are now very modest, so share price discounts can no longer be justified on the basis of financial distress even in the UK's moribund housing market.
Table two: FTSE 350 Housebuilders' fey financial data
| Company | Share price (p) | Share price performance in 2011 (%) | Market value (£m) | Discount to NAV (%) | Gearing (%) |
| Barratt Developments | 90 | 1.6 | 968 | 70 | 11 |
| Bellway | 693 | 3.4 | 837 | 21 | 2 |
| Berkeley | 1281 | 42.9 | 1728 | premium | Net cash: £13.9m |
| Bovis | 427 | 4.3 | 571 | 20 | Net cash: £46m |
| Persimmon | 462 | 11.4 | 1391 | 23 | 1 |
| Redrow | 112 | -16.8 | 348 | 24 | 16 |
| Taylor Wimpey | 36.5 | 16.8 | 1189 | 32 | 9 |
Source: Investors Chronicle | |||||
A smart way to trade
The risk this year is that even undervalued stocks will be dragged down in a general market rout. That may indeed happen, but it is interesting to note that only once (in 2000) in the last 32 years has the housebuilders index fallen more than the UK market when equities ended the first quarter in negative territory. On the other eight occasions when the UK market fell in the first quarter, the housebuilders outperformed the index by an average of 11.9 per cent. In other words, it's pretty rare to see the sub-sector underperform in this specific three-month period when the market falls. Moreover, when the market rises we can expect absolute outperformance.
Therefore, my recommended trade is to buy shares in the seven housebuilders above in equal portions and hedge off this long position by simultaneously buying put warrants on the FTSE 100 to create a classic long-short pair trade. The aim is to try to generate the 7.3 per cent 'alpha' the housebuilders sub-sector has returned in the first three months of the year since 1980. For the short side of this trade, I am advising using the FTSE 100 as this is a very good proxy for the FTSE All-Share given the blue-chip index accounts for around 80 per cent of its weighting.
Choosing a warrant
The put warrant that appeals most for this trade is Societe Generale, SY29, which has an expiry date of 16 March 2012, exercise price of 5900 and parity of 1000:1. So, with the FTSE 100 priced at 5500, the put warrants are trading on a bid-offer spread of 50p to 50.5p (equivalent to 505 index points) and are effectively geared 8.3 times to movements in the index. This means that 40p of the warrant price is 'in-the-money' and 10.5p is 'out-of-the-money' and will erode over time.
Having worked through various scenarios, an investor looking to commit £21,700 on this trade needs to buy 3,400 Societe Generale SY29 put warrants at a cost of £1,717 to create a £20,000 short position on the FTSE 100 until mid-March to offset a combined purchase of £20,000 of shares in the seven housebuilders.
To see how this trade works in practice consider the following scenarios when the warrants expire in mid-March:
(1) FTSE 100 is trading at 5500 and SY29 falls from 50.5p to 40p, valuing the put warrant holding at £1,360. In this scenario, shares in the seven housebuilders would have to rise by an average of 1.8 per cent to create a gain to offset the £357 loss on the put warrants and breakeven on the pair trade (excluding stamp duty and dealing costs).
(2) FTSE 100 rises 4.5 per cent to 5750, SY29 falls from 50.5p to 15p and the warrant holding is worth £510. Shares in the housebuilders need to rise by an average of 6 per cent to offset the £1,207 loss on the put warrants (excluding stamp duty and dealing costs).
(3) FTSE 100 falls 4.5 per cent to 5250 and SY29 rises from 50.5p to 65p to produce a profit of £493 on the put warrants. As long as shares in the housebuilders fall by less than 2.5 per cent we turn a profit on the pair trade (excluding stamp duty and dealing costs). And if they rise then we make a profit on both sides of the trade as was the case in 2009 when the strategy produced an eye-catching 26.6 per cent net return.
(4) FTSE 100 falls 10 per cent to 4950 and SY29 put warrants rise from 50.5p to 95p to produce a profit of £1,513 on the warrant holding. As long as shares in the housebuilders fall by less than 7.5 per cent we make a net profit on the pair trade (excluding stamp duty and dealing costs).
A major benefit of this type of long-short pair trade is that we have an effective hedging mechanism in place to guard against periods of market turmoil and heightened risk aversion. Moreover, dealing costs can be kept low by trading through execution-only brokers. There is, of course, the chance that this could be the one year, as was the case in 1985, when the housebuilders sector falls and the market rises, in which case we would lose on both sides of the trade. However, that is a risk I am willing to take on. I will update this trade before the put warrants expire on 16 March and will offer further advice at that time.
