I always advocate putting stop-losses on your positions since they can save you a lot of money if markets suddenly go against you – as happened to our longs during the crash last month. However, the downside of stop-losses is that short-term market turbulence can force you to exit bets that offer good long-term potential. While I still think that the pros of stop-losses outweigh the cons, the recent market rally means that I am re-examining United Rentals (NYSE: URI), one of the tips that was automatically closed out during the recent implosion.
I tipped United Rentals in February for two main reasons: firstly, it was cheap relative to earnings, especially compared with the overall US market (which was extremely expensive at that time). I also felt that because it was an equipment rental firm that got most of its revenue from North America, it would benefit if there was a move significantly to increase infrastructure spending in the United States. With politicians across the political spectrum agreeing that more money needs to be invested in America’s infrastructure, which is generally deemed sub-par, I felt that there was a good chance that this could happen.
A second chance
The current crisis has only reinforced these views. United Rentals was badly clobbered in the meltdown, losing half its value at one stage. Despite a recent rally it is still at $108, down 30% from where I originally tipped it. Even though its earning estimates for the next two years have been revised downwards, it now trades at just six times 2021 earnings (compared with seven times when we last looked at it). This looks extremely cheap for shares in a company that managed to grow earnings by an average of 10% a year between 2014 and 2019 while maintaining a double-digit return on capital expenditure.
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With the US economy heading for a deep recession even after the current lockdown measures are relaxed, there is a growing consensus that an additional fiscal boost will be needed. The current measures have concentrated on stopping firms from going bankrupt and giving them an incentive to keep workers on payrolls.
But it looks as though the Democrats will insist that the next round of fiscal loosening also include a large amount of infrastructure spending – something that Trump will no doubt have to agree to, given that he has little choice if he wants to be re-elected in November.
The fact that one of United Rental’s directors has also taken advantage of the crash to increase his holdings is also a good sign. I therefore suggest that you go long at the current price of $108 at £36 per $1. To prevent you being stopped out too early, I recommend a stop-loss of $74, which would take you below the bottom in late March. This gives you a total downside of £1,224.
Trading techniques: the gap in the oil market
The oil market is made up of several different types of crude oil, depending on where the oil is drilled and its chemical composition. However, the two types primarily used as global benchmarks are West Texas Intermediate (WTI) and Brent Crude. Brent crude is oil that comes from the North Sea and is traded on London’s Intercontinental Exchange; West Texas Intermediate oil comes from Cushing, Oklahoma and is traded on the New York Mercantile Exchange.
Since both types of oil are chemically similar and the oil market is globalised (especially since the ban on US oil exports was lifted in 2016) the prices of both types of oil tend to follow each other closely, with a long-term correlation of around 90%. However, there is usually a small difference in price between the two types (Brent now sells for $31 a barrel; WTI, $23) and this is known as the Brent/WTI spread. The spread can appear for a number of reasons, such as production levels in both the US and North Sea, demand for oil in the US, or geopolitical tensions.
As the two types of crude have followed each other so closely, many traders assume that the spread will remain roughly constant over the long run. So they tend to employ a mean-reverting strategy, shorting WTI and going long Brent when WTI rises relative to Brent and doing the opposite when Brent rises relative to WTI. A 2014 study by Thorben Lubnau of the European University Viadrina in Frankfurt found that this strategy would not only have earned positive risk-adjusted returns for the overall period between 1992 and 2013, but would also have made money in each five-year period within this time span too.
How my tips have fared
The portfolio has undergone huge change during the market meltdown and recovery of the past few weeks. However, the last fortnight has brought some stability, with both of the long tips rising as the market continues to rally on hopes that some of the restrictions could be eased in the next few weeks.
International Consolidated Airlines Group went up from 200p to 247p. Oil giant Royal Dutch Shell climbed from 1,300p to 1,509p, thanks to several agreements between the world’s major oil producers to cut production by 10% in order to bolster the price of crude oil.
As you might expect, given the general rise in the market over the last fortnight, all of my three short tips also appreciated. However, the gains were smaller than the hefty increases in my long tips.
For example, fast-food chain Shake Shack advanced from $40 to 42.85, while cigarette company Philip Morris International went up from $69.15 to $73.95. Minicab firm Uber made an even smaller gain, inching up from $27.28 to $27.99. Overall, my short positions are making a total of £2,042 in profit. In conjunction with the £298 of winnings from my current longs, this brings the total to £2,340.
Given the recent high portfolio turnover and the fact that I have a total of only six tips (counting United Rentals), I would not recommend that you close any of your positions.
However, I do think that you should lock in some profits on your shorts by adjusting the stop-losses. So consider reducing the price at which you cover your position on Uber from $45 to $35. I would also suggest that you reduce the stop-loss on Philip Morris International from $110 to $85 and on Shake Shack from $73 to $57.
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