Analysis: Tactic plays flourish for range-bound equities

By Blaise Robinson and Harpreet Bhal

PARIS/LONDON (BestGrowthStock) – With equities stuck in a range and long-term investors sidelined by high volatility, alternative trading strategies are set to make gains as long as the market zigzags.

Cross-asset correlations, index trackers, technical analysis and algorithmic programs are drawing more interest on trading desks and from hedge funds that are playing short-term moves until the economic picture comes into sharper focus.

“It’s a more complex market, not for the mom-and-pop investors,” IG Markets analyst Vincent Ganne said.

“It’s range-bound but not dull. If you’re creative enough, it offers good opportunities to play strategies such as correlations between asset classes.”

Since early May, the S&P 500 (.SPX: ) and Euro STOXX 50 (.STOXX50E: ) indexes have been bobbing in a range about 12-15 percent wide, staging brisk rallies quickly followed by sharp retreats that have left traditional investors feeling dizzy.

For Steven Bell, director at hedge fund GLC, the market’s lack of direction is forcing equity investors to be more active.

“We’re running light on risks, looking at tactical trades more than strategic trades,” he said.

The usual long-only strategy relying on sector picks has not been good enough for antsy hedge funds and traders, as virtually all sectors have been range-bound since April.

Traders instead have turned to correlation strategies — such as the one between the euro and European stocks — to get their ‘buy’ and ‘sell’ signals.

“Stocks and the euro have been moving hand in hand, and the euro has clearly been calling the shots. When you know that, you see where stocks are heading,” said David Thebault, head of quantitative sales trading at Global Equities.

The euro, which has had a daily correlation of +0.9 on a rolling 25-day average with the Euro STOXX 50 index for most of August, has been a key barometer for foreign investors trading euro zone stocks since the region’s debt crisis, Thebault said.

A perfect positive correlation of 1 implies that two assets are moving in lockstep.

TURNING TO INDEX TRACKERS

The correlation has been even stronger with the volatile banking stock index (.SX7P: ), reaching +0.98 in early May.

Investors buying shares of Commerzbank (CBKG.DE: ), Societe Generale (SOGN.PA: ) and Santander (SAN.MC: ) right when the euro started to bounce back in early June and selling them when the currency broke out of its uptrend channel on August 10 — ignoring the strong quarterly results the three banks had just posted — made gains ranging between 32 percent and 55 percent.

Another strong correlation that has been on radar screens is the one between individual stocks and equity indexes.

While this correlation remains very high as market players are reluctant to bet on particular names, investors have been increasingly putting money into Exchange Traded Funds (ETFs).

European ETFs — a fast-growing market dominated by funds from Deutsche Bank (DBKGn.DE: ), BlackRock’s (BLK.N: ) iShares and Societe Generale’s (SOGN.PA: ) Lyxor — replicate indexes’ performances, giving investors exposure to the underlying assets but at a lower cost and with more short-term flexibility.

“As uncertainty increases…people are less brave about committing heavily to individual stocks. There is some safety in trading the indices,” said Geoff Wilkinson, head of investment research at Mint Equities.

Strong appetite for index trackers will likely continue, at least until a clear picture of the economy’s direction emerges.

Investors have also turned to technical analysis while dropping traditional valuation tools such as price-to-earnings ratios because of the lack of visibility on the denominator.

Charts on the S&P 500 and Euro STOXX 50 show investors have been keen to book gains when the indexes flirt with key resistance levels and buy when they fall toward support levels, using Fibonacci retracements and moving averages as fences.

“In times of uncertainties, the number of people turning to charts and Fibo levels increases a lot and, in a way, it becomes a self-fulfilling prophecy that even the most skeptical investors can’t ignore,” a Paris-based trader said.

Some hedge funds and trading desks at big investment banks have also turned to algorithmic and high-frequency programs, which seek big gains from even a small price move because of the speed at which they trade and the high volumes involved.

Most of these programs, which now represent a big chunk of trading volumes on U.S. and European bourses, thrive when stocks are range-bound because they are market neutral.

“A trading range is the preferred playground for high volume players. It’s rather easy to catch non-professionals off guard and make a profit,” said Christian Blaabjerg, head of equity strategy at Saxo Bank in Copenhagen.

He thought trading ranges would prevail until markets got a handle on U.S. and European GDP growth prospects for 2011.

“And given the current macroeconomic outlook, the establishment of a new strong trend in either direction won’t be around the corner any time soon.”

(Editing by Michael Shields)

Analysis: Tactic plays flourish for range-bound equities