Stock Quotes in this Article: BAC TA SIRI PHM PPC

MINNEAPOLIS (Stockpickr) -- This market is so unbelievably predictable. After another brush with death, stocks rebounded. They have been going up for several days in a row. The Dow is now in positive territory.

Can you say, “Dead cat bounce”? We’ve seen this story before. Are you going to get sucked into buying stocks now that the carnage is in the rear view mirror? Before you do, think twice.
The rally of late began with Warren Buffett making a billion dollar splash by purchasing Bank of America (BAC) preferred stock. That claxon call sounded the all-clear and bulls were off to the raises. Ah, but wait a moment. Are we not in the last days of summer when most professional traders and money managers are on vacation?

What happens after Labor Day when everybody returns to work? Has anything really changed? The answer is nothing much. We are in the midst of a waiting game. Given the heavy speculation about a double-dip recession, investors must collect data to determine if that speculation is correct.

Economies work that way. There is no one single data point to tell us that a recession is here. It will simply take time for the numbers to come in. When the hard truth arrives market participants will be better able to determine fair market value. In the meantime we can expect the market to trade in a tight range.

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    Instead of riding that roller coaster I have suggested that investors take a different approach to the market by making select pair trades in search of absolute returns. Simply owning a stock long matched against a short position can help you make money no matter what direction the market is heading. The general idea is to own a stock that will go down less in a bear market while making more money in a bull market and vice versa.

    This week my pair trades will focus on stocks that trade for under $5 per share. Within this category there is fertile ground to identify winners and losers that can be used for a pair trade. In fact, I find stocks under $5 to be the easiest place to spot stocks that will make it and stocks that won’t. More importantly if one is correct in the analysis, big money can be made on both sides of this trade.

    In the last two weeks I have seen many stocks trading for under $5 that are getting pummeled in this market. At the same time, some very good companies with share prices below $5 are hanging in their very well in this environment. Here are 2 under $5 stock pair trades:

    Long Travel Centers of America/Short Sirius XM Radio

    With stocks under $5 the key factor in a market of uncertainty and nervousness about a possible recession is profits. Investors are quite unforgiving when it comes to companies making money vs. companies losing money. There is simply no appetite for dreams no matter how big.

    It makes sense that investors would re-evaluate prospects of companies trading under $5 per share at the end of a bull cycle. These companies tend to be on the edge of profitability and require the momentum of positive GDP growth to keep the dollars flowing. If economic activity reverses course profits can evaporate and losses accelerate. Those losses can be substantial hence the unforgiving nature of investors when it comes to a less than $5 stock that appears wobbly.

    In searching for a pair trade then, absolute return investors would be wise to focus intently on earnings and future earnings expectations when selecting stocks for a pair trade. My choice for the first pair trade is Travel Centers of America (TA). This recently recapitalized company operates truck stops across the national freeway system. The small-cap stock is one that is solidly in the black with future profit growth expected to be strong.

    In the most recent quarter ending June 30, 2011, Travel Centers reported profits that greatly exceeded analyst estimates. The company made $1.01 per share vs. the average Wall Street estimate of 77 cents per share. The stock traded higher after the news, but dipped below $4 per share during the last market sell-off. While shares have rebounded to $4.50 per share today, the stock is still inexpensive relative to expected profits and growth.

    Investors can buy Travel Centers for just 11 times current year profit estimates that are expected to double in 2012. Buy Travel Centers long in a pair trade. On the short side of this trade I will take Sirius XM Radio (SIRI). The satellite radio company has been fighting hard to make a profit. A recession would severe hurt its prospects as consumers tighten budgets and eliminate discretionary spending on things like satellite radio.

    Considering the company has a market capitalization closing in on $7 billion, investors will be greatly disappointed should profits become elusive in a recessionary environment. Sirius is a stock that has plenty of passionate believers. No doubt the potential of its products combined with its virtual monopoly are enticing to investors.

    The problem is timing. The window for this company to make its mark is beginning to dwindle. While Satellite dominates terrestrial radio, competition from smart devices and the like will make it difficult for Sirius to reach its full potential. I was a believer in the story at one point, but I am no longer. Sell Sirius short in a pair trade of under $5 stocks with Travel Centers of America.

    Long Pilgrim’s Pride/Short Pulte Group

    If there ever was an industry teetering on the edge it would be the homebuilding sector. This already beaten up industry cannot afford a double dip recession. Companies in the space have lost much and will likely lose more if the economy contracts.

    I’ll short Pulte Group (PHM) in a pair trade. The company is on pace to lose 22 cents per share this year. Analysts are expecting the company to make 19 cents per share in 2012. Those numbers are likely to be too optimistic for an economy on the downturn. Shares of Pulte trade for less than book value, but if the company keeps losing money that book value will shrink in a double-dip environment.

    Foreclosures are still a major problem for the industry. In a market with too many sellers and not enough buyers Pulte is likely to struggle no matter what the economy does from here. The recovery of the homebuilding sector will take many, many years.

    On the long side of this pair trade I would buy long shares ofPilgrim’s Pride (PPC). The big chicken company has been hurt by increasing feed costs. At a time when the company is attempting to return to profitability, slimmer margins are painful. Investors have sold the stock hard over the last year with shares dropping from a high of $8.61 per share to its current price of $3.50.

    Although Pilgrim’s is losing money, a trait I mention earlier as being problematic for a stock trading under $5, I would view this company as more of a defensive play. Consumers will eat poultry no matter what is transpiring in the economy. The volatility of sales and profits are likely to be less with Pilgrim’s than other stocks with similar traits. As such, I would look for the company to continue its turn-around and investors to be long this stock in a pair trade.

    To see these trades in action, visit the 2 under $5 stock pair trades portfolio on Stockpickr.

    RELATED LINKS:

    >>2 Pair Trades for Big Swings in the Market

    >>Buy These 5 Pummeled Clothing Retailers

    >>5 Stocks Flashing Insider-Buying Alerts

     

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    -- Written by Jamie Dlugosch in Minneapolis.

    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.