A defensible pairs trade

February 18, 2016 09:00 AM

Aerospace and defense companies had a rough 2015. The industry ranked 94th out of 100 for U.S. stock performance for the year, falling about 9% (8% relative the S&P 500). The underperformance is a continuation from last year with increasing trajectory, as the industry underperformed the market by 5% in 2014.

This is a far cry from 2013, where the iShares U.S. Aerospace & Defense ETF (ITA) was up 51.27%, almost doubling the S&P 500 and with just about all of that coming in the second half of the year alone.

We used the EidoSearch predictive analytics engine to interrogate some of the patterns in the sector and to see if some of the statistics stood out. We started by analyzing the patterns at the aggregate level (industry and ETF), but that didn’t yield anything compelling so we dug a bit deeper and looked at the price patterns for all U.S. Aerospace & Defense stocks. With an election on the horizon, it’s difficult to project too far in advance, so we focused on finding stocks with outlier return probabilities to the positive or negative side for July 1. There were two that stood out: Triumph (TGI) and Northrop Grumman (NOC).

Although TGI and NOC have traded in a highly correlated fashion historically, “Fork in the road,” shows where they diverged in the beginning of 2014. Not only that, but in comparison to the industry (middle pattern for iShare’s Aerospace & Defense ETF), they have both continued to build on their cumulative outperformance and underperformance. 

“Pair trade?” shows that TGI and NOC have the most positive and negative projections in the industry. Both show some reversion to the mean, especially in the case of TGI which projects high probability for a significant rebound.

We also checked the full year projections, and longer term patterns for both stocks, and the return to the pack holds true. NOC is still the most negative projection in the industry and TGI is the 10th most positive for the year.

About the Author

Dr. Steven Zhang is the CEO at EidoSearch.com, a  Ph.D. in electronic engineering and an internationally renowned expert in information processing technologies. His expertise is in the areas of signal processing, multimedia content analysis, computational intelligence, pattern classification, as well as, applications in bioinformatics and finance.