Pairing Up

By Daniel Kadlec

In case you haven't noticed, the stock market is going nowhere. Sure, last year the Dow rose 25% from depressed levels in 2002. But the average stock is down again this year and has been dead money for more than five years. Since the Dow first closed above 10,000, in March 1999, it has crisscrossed that milestone 21 times and hovers near there today.

This humdrum era for stocks, which analysts say could last at least several more years, has given new life to strategies designed to profit in a stalled market. All but vanquished during the long bull run of the 1990s, "market timers"--who try to catch a stock's highs and lows as it trades in a narrow range--are sprouting again. So are "market neutral" investors, who through options and other techniques try to hedge away any market movement but gain from temporary stock-price discrepancies.

Those strategies have their problems. For one, picking highs and lows based on recent trends works only until the trends change, and that can happen at any time. The surest way to maximize returns in a dull market is to rebalance your portfolio once a year to preset levels of bonds, cash, real estate and large-cap, small-cap and foreign stocks. You automatically sell what has done best (while it's up) and buy what has done worst (while it's down). But even rebalancing falls short when nothing moves higher.

One strategy for making money in a sideways market is called pairs trading, a technique often used by hedge funds. A pairs trade hinges on identifying two stocks that tend to move together but for some reason have gone opposite ways. Buy the stock that has lagged and sell short (a bet it will decline) the stock that has zoomed ahead. "You have to believe the historical relationship will re-emerge," says Seth Weiss, co-founder of Denver-based Pairs Trading. The direction of the market won't matter. As the two stocks fall back in synch, the pairs trade hits pay dirt.

Some mutual funds trade in pairs, though their performance has been spotty. The Laudus Rosenberg, GMA Gabelli and Franklin U.S. long-short funds and Phoenix Market Neutral sometimes give the pairs game a spin. But, says Dan McNeela, an analyst at the fund-research firm Morningstar, "these kinds of funds tend to have above-average expenses."

If you're the type who likes to take charge and shoot for gains in a directionless market, pairs trading on your own may be for you. Weiss, whose firm searches for stock pairs that have diverged, says there are hundreds of pairs a day that present opportunity. To keep it simple, he says, stick with pairs of big stocks in the same industry and pairs with similar long-term trading histories. Put them on your screen and wait for them to get out of whack--either when they go in opposite directions or when one severely lags the other for at least three days in a row. Unwind the trade if the divergence persists and your losses reach 3% or after the stocks are back in synch and you have a gain--typically of about 7%. Here are three pairs popular with pros:

HOME DEPOT, LOWE'S These home-improvement stocks are in lockstep 88% of the time and typically get back in synch within three weeks of diverging.

FORD, GENERAL MOTORS These automaker stocks move in tandem 93% of the time and after going their separate ways typically regroup in about two weeks.

MERRILL LYNCH, MORGAN STANLEY These brokerage stocks trade alike 92% of the time and after disconnecting typically rejoin in about two weeks.

Disregard any stock movement on the heels of bell-ringer news like fraud charges or a new asbestos liability. But modest earnings surprises that cause a stock pair to decouple often present opportunity--a rare commodity in a market going nowhere.