Stock Quotes in this Article: CBOU, CMLS, SBUX, SIRI

Pair trade corner

MINNEAPOLIS (Stockpickr) -- The market is in full rally mode. Exuberance over an economic recovery fueled by easy money policy and fiscal stimulus has resulted in stocks finishing 2010 in fine form. Stocks are now up more than double digits for the year.

Not bad considering all the negativity and bad news that seemed to be permeating the markets for much of the year. One can reasonably ask if the gains are justified or simply manipulation of the system.

On one hand, the business cycle would suggest that we are due for economic expansion. It is the natural way of things. Given the depth of the last recession, it is not unreasonable to see things expand as they have over the last 12 months.

On the other hand, one could view recent gains as simply being a case of manipulation. The Federal Reserve does not want investors in bonds. They keep interest rates low as to discourage income investing. The goal is to stimulate risk-taking, and risk-taking is what we have seen of late.

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    Gains in the market then could just be a mirage. We want to believe it is true, but it all may be just another house of cards. How does an investor protect capital in such an environment?

    That’s where an absolute return or long-short strategy can help. If markets continue to go higher, a long position will gain. If markets drop, the investor is protected with the short position.

    It is not that complicated, and the best way to implement such an approach is with pair trades. Going long a stock thought to be undervalued combined with a sale short of a stock thought to be overvalued can result in incremental gains and more importantly capital preservation.

    Here are two pair trades to consider.

    Long Caribou Coffee, Short Starbucks

    Is it just me or is Starbucks (SBUX) pulling a bit on the string? After years of impressive growth, the king of coffee hit a roadblock during the recession. Since then, it has attempted many things to right the ship.

    Among its many initiatives were closing nonperforming shops, adding food items, testing beer and wine sales -- and any other ideas from the masses thought to be worthy of implementation.

    The result was a return of some steam, but the sustainability of recent gains is very much in question. What exactly is Starbucks today, and where will the growth come from? Is it competing with McDonald's (MCD), or is it competing with other coffee shops?

    The answer is vague at best. It's not that Starbucks is a bad company or even a horrible investment. But investors may find better opportunities elsewhere.

    One place to look elsewhere is the more pure coffee shop play of Caribou Coffee (CBOU). Unlike Starbucks, which must rely on gimmicks to find its growth, the opportunity for Caribou is extension of its brand and the opening of more stores.

    It has found a formula that is working on a per-store basis, opening the door to a very large market. That large market provides the growth prospects and earnings momentum that is positive for stock investors.

    Starbucks operates nearly 20,000 stores. Caribou is well under 1,000 locations. China and other foreign countries may provide solid growth opportunities for Starbucks, but I would rather bet on the small operator here.

    The two companies make for a great pair trade for absolute investors with a long of Caribou and a short of Starbucks.

    Long Sirius, Short Cumulus Media

    Sometimes investing is as simple as riding the waves. New businesses are formed and thrive, pushing out those businesses that fail to innovate or simply try to hold on to past glory.

    As that drama plays out, there are gains to be had on both the long and short side of a trade. This story is playing out currently in the radio space. Specifically, satellite radio is slowly but surely pushing aside terrestrial radio.

    For pair-trade investors, the opportunity is to go long Sirius XM Radio (SIRI) while shorting Cumulus Media (CMLS). On the surface some may scoff at such a notion, but over the long haul, there is little doubt which stock will win and which stock will lose in this battle.

    Sirius Satellite is essentially a monopoly with a superior product. It sells its satellite radio in a monster market with little to zero competition. It can obtain talent without worry of bidding up prices as it just did with the retention of Howard Stern, and its content is far superior to terrestrial radio offerings.

    Some may say that Sirius is overvalued, but it's not when you consider that subscriber growth could double or triple from current levels. More important, Sirius can raise prices without worry about retaliation.

    Sirius will be printing money. On the flip side, terrestrial radio has little hope. It may take years to play out, but where is the future growth in terrestrial. It is nonexistent. That and that alone make Cumulus an easy short.

    Shares of Cumulus have increased of late making this an easy pair trade opportunity. I would go long Sirius and sell short Cumulus.

    To see these stocks in action, check out my Pair Trade Corner 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.