Stock Quotes in this Article: AN, BAC, LAD, MA

MINNEAPOLIS (Stockpickr) -- Cut through the current debate regarding a double-dip recession, and you find economy that is stagnant at best. The Federal Reserve has lowered growth expectations to paltry levels. Nobody is predicting booming growth any time soon.

As stock market participants weigh the possibilities, we seem to swing from one extreme to another. Stocks go up one day only to lose value the next. When stock values do rise, they seem to do so for technical or opportunistic reasons. The buyers are far from long-term players in the market.

What is an investor to do in such an environment? There are plenty of strategies, of course, but doing nothing should not be an option.

At the moment, options are getting their fair share of attention. I’ve met many astute investors that are writing option contracts against positions that are owned in portfolios. In doing so, they collect the premium on the contract if stock prices fall. If a contract expires without execution, the call writer keeps that premium. With the volatility in the market, option prices are steeper than normal. Using this strategy is a great way to augment returns. Use it on a stock that pays a dividend and you could collect total returns of 8% to 10%.

A less-complicated approach, and one favored by some of the most successful hedge fund and institutional managers on Wall Street, would be to follow an absolute returns strategy. The idea is to take a long position in a stock and pair it with a short of another stock in attempt to capture relative outperformance and absolute returns, regardless of market direction.

Here are two pair trades for a stagnant economy.

 

Long Lithia Motors/Short AutoNation

To be a successful absolute returns investor, you need to identify inefficiencies in the pricing of stocks that can be exploited in a pair trade. Inefficiencies can occur for any number of reasons. In the auto sector, the earthquake in Japan created a shock to the industry that has created a pair trade opportunity that absolute returns investors can exploit.

Specifically, in the car-selling space investors have gravitated to the perceived safety of larger car dealers such as AutoNation (AN) while pulling back from smaller players such as Lithia Motors (LAD). The result is a relatively wide valuation disparity that over time absolute return investors can expect to narrow.

On the long side of this pair trade is Lithia Motors. The $412 million market cap company owns and operates car dealerships in 12 states, mainly in the west and Northwest. Lithia locations sell new and used vehicles, covering 26 different brands. While inventory of Japanese brands fell in the aftermath of the earthquake, the company was able to absorb the disruption by selling other brands as well as used cars.

Operating performance at Lithia has greatly exceeded expectations in each of the last four quarters. Up until July, shares of Lithia had moved steadily higher as a result of strong profits. Despite share appreciation and including the recent pullback in shares price since mid-July, Lithia shares are cheap. Wall Street expects the company to make $1.70 per share in the current year, with that number growing 13% to $1.92 in the following year. At current prices, the stock trades for just 9 times current-year earnings estimates.

Lithia, one of the highest-yielding specialty retail stocks, shows up on an August list of 10 Small-Cap Stocks With Positive Earnings Trends.

AutoNation is a $5.7 billion market cap company with more than 200 dealerships across the Sunbelt. Like with Lithia, operating performance at AutoNation has been strong. The company has beaten estimates in each of the last three quarters. That said, the margin of those beats is significantly less than what Lithia delivered.

Shares of AutoNation have been on a straight path higher over the last year, with the stock up more than 70%. AutoNation did slip in July, but shares have recovered the entirety of that lost value over the last month. The stock shows up on a recent list of the 10 Best-Performing S&P 500 Stocks of 2011. I can appreciate the enthusiasm for investors to own a large and profitable business that is doing well compared to analyst estimates, but AutoNation shares are expensive today.

The average Wall Street estimate is for the company to make $1.91 per share in the current year, with that number growing 12.5% to $2.15 in the following year. At current prices, shares of AutoNation trade for 20.5 times current year estimates of earnings. That is too rich.

I would be long Lithia and short AutoNation in this pair trade.

 

Related: 5 Auto Stocks to Watch

 

Long Mastercard/Short Bank of America

One of the reasons the market is struggling lately is the lack of participation from the financial sector. Banks are reeling thanks to increasing odds of another financial meltdown -- this one triggered by the collapse of banks in Europe. Banking and financial stocks in general have been among the hardest hit during the recent stock market correction.

The environment of volatility, increased fear and capitulation by investors is fertile ground to find pair trade opportunities. The way I would play the industry would be to ignore or short those stocks with balance sheet issues while going long financial businesses with stable cash flow. The safety of that cash flow is likely to outperform the questions regarding balance sheets for at least another year or two, maybe more.

On the long side of the equation, the place to find stable cash flow is in the credit card business. MasterCard (MA) makes money every time a card is swiped. There are no worries about asset write-downs or the need to raise capital here. Consumer confidence may be down, but spending appears to be holding. Retail sales for August were strong.

MasterCard is a profit monster. The company has greatly exceeded average Wall Street estimates in each of the last four quarters. Those analysts expect the company to make $17.73 per share in the current year, with that number growing 17.5% in 2012. Investors can buy that growth for just 19 times current-year profit estimates.

MasterCard, also one of the 10 Best-Performing S&P 500 Stocks of 2011, shows up in Warren Buffett's Berkshire Hathaway portfolio -- Berkshire increased its position in the stock by 87.5% in the most-recent quarter -- and one of the top holdings of Julian Robertson Tiger Management.

On the short side, the easy target is Bank of America (BAC). The much-maligned bank continues to struggle under the weight of poor acquisition decisions just prior to the collapse of the housing market. Short-sellers have attacked the company, speculating that the bank would need to dilute current shareholders by selling common stock.

Warren Buffett coming to the rescue has helped stabilize Bank of America shares, but investors would still be wise to stay away from this stock. When Buffett did a similar deal with Goldman Sachs in September 2008, the vote of confidence was temporary. By the end of the year, shares of Goldman collapsed losing nearly half their value.

Related: 4 Stocks to Buy to Be Like Buffett

Buffett's deal makes money for Buffett. Common shareholders may or may not be so lucky. At a minimum, the future for Bank of America is uncertain. I would short Bank of America in a pair trade with the more certain future of Mastercard.

To see these stocks in action, visit the 2 Pair Trades for a Stagnant Economy portfolio.

-- Written by Jamie Dlugosch in Minneapolis.

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At the time of publication, author had no positions in stocks mentioned.

Jamie Dlugosch is a founder and contributor to MainStreet Investor and MainStreet Accredited Investor. Formerly, he was president and CEO of Al Frank Asset Management. He has contributed editorially to The Rational Investor, The Prudent Speculator, Penny Stock Winners and InvestorPlace Media.