Selling volatility works, until it doesn’t

Since February, yields have compressed to the point where I am getting a bit suspicious that we are going to see some spreads widen again whenever we get some sort of credit event that will cause another round of financial distress. I am not forecasting when this will happen, but historically speaking, the lead-up to the presidential election always causes unwelcome volatility. Right now the assumption is that Hillary will win, but between now and the early November election date, things will change when the public actually starts to pay attention again to their two choices.

The markets, however, do not appear to indicate to price in much risk. Following is a chart of the VIX:

vix

The last time volatility got that low was back in the middle of 2014 (remember when oil was at US$100/barrel?).

Volatility is typically anti-correlated to positive price movement. Right now, investors that sell risk on the main index are not receiving much money for what is a piddling amount of yield – an at-the-money option sold a month out on the S&P 500 will only yield an investor about 1.1% on their at-risk amount, which is very, very, very low. Looking out nearly 5 months to mid-January, that same premium is 3.7%.

In the event of a market crash, an investment in put options not only profits due to the pricing differential between market and strike, but also due to the increase in volatility that occurs during turbulent markets. There’s probably never been a better time to invest in a potential market crash than right now, but the phrase that says markets can be calmer for longer than one can remain solvent applies.

Indeed, I am seeing many market prognosticators talk about skepticism of the existing market conditions, that the indexes (which are at all-time highs) are sputtering, that the economy recovery is long in the tooth, etc, etc. This does not bode well for crash conditions, which happen when there is stress and underlying causes to force entities to liquidate at all costs.

I can’t conceive what could cause crash conditions other than a major WMD event to the scale of a 9/11.

I still believe that a cautious approach is appropriate and that the market participants that will get the most out of the market will do so on the fixed income side. However, these opportunities I have noticed have basically vanished from the good risk/reward column to just ordinary. Ordinary valuations are good enough for me to hold onto things, but not nearly enough for me to invest in.

I was fortunate enough to fully participate in this market cycle, but in general at present, I am in a very slow liquidation mode as I do not see much worth investing in. There are a couple portfolio components (fixed income) that are trading at prices that are within 5% of me dumping it, but I am no rush for them to get there – I will keep collecting dividends, distributions and interest to pay down the very low interest margin debt. In general, I see about a maximum capital appreciation of about 15% in the remaining portfolio for still relatively low risk – even if the actual appreciation is zero, the weighted average coupon is 7.9% and I get paid to wait.

If we get some sort of spike that caused a general portfolio rise of 10%, I would have sold enough to have a healthy double-digit percentage cash balance. If this portfolio spike was 15% from present levels, the only things I’d be holding would be my bonds to maturity (unless if those too were trading ridiculously above par value). Then I would go on vacation and wait a long time.

Sometimes I am furiously active on trading, and sometimes there are very dull moments. The past few months have been very dull and I’ve been twiddling my thumbs. My investment strategies have been working and there will be a time to shift gears once my current strategy has run out of gas. Just not today.

US Presidential Election Update

The Republicans are having their national convention this weekend. Donald Trump will be nominated as their candidate for president, something that most pundits saw as a joke when he announced last year.

Readers should be cautioned that the national polling figures for the USA are nearly useless in determining the closeness of the presidential race. Three major states with huge populations, California, Illinois and New York, are very heavily Democratic-leaning and they will not be seriously contested during the election. These states will involve lop-sided victories and will skew the numbers.

Instead, readers should be looking at the following states (electoral votes in brackets):

Florida (29)
Pennsylvania (20)
Ohio (18)
Michigan (16)
North Carolina (15)
Arizona (11)
Wisconsin (10)
Iowa (6)


Click the map to create your own at 270toWin.com

 

Note it is very probable that Hillary Clinton requires 270 to win, while Donald Trump requires 269 to win.

I will be reverting my previous prediction of a “landslide” to a moderate victory for Donald Trump. As readers can infer from this map, the Republicans have much more “work” to do to win these swing states than the Democrats. That said, the nature of elections in Canada and the USA depend on a factor of voter turnout, something that polling does very poorly – the primary component of this assumption is that Trump has the ability to get out previous non-voters due to his non-political methods.

I will also state that I do not endorse the policies of either candidate. It is simply a prediction of what I believe will happen given what is going on in the USA political landscape. From a market investment perspective, it is likely the fruition of Donald Trump’s policies will cause considerable volatility in the markets and the markets are not sufficiently bracing for impact.

Brexit – Impact

Market volatility has been high leading up to and including after the Brexit referendum results. The VIX has climbed up to around the 25 level which is above the average ambient temperature of 15, but not ridiculously high (last August, for example, there was a spike up to 50 and I’m struggling to remember what calamity was the order of that day).

The UK exiting from the EU causes uncertainty in the minds of money managers. Whenever uncertainty is high, the natural desire is to raise cash and reduce portfolio risk, so futures get sold. This triggers automatic liquidations of underlying equities and debt portfolios, which leads to broad-based asset price decreases as the liquidations occur. There also may be some margin liquidation going on for more over-leveraged players.

Eventually this vicious cycle ends – the trick is anticipating when the vicious cycle ends. I believe it will be sooner than later, although the choppyness of the market will continue to confuse most market participants into believing that we are either entering into the new dark ages, or a golden era of economic productivity when neither seems to be the case.

Canadian Preferred Share price appreciation nearly done

Preferred share spreads (in relation to government) have compressed significantly since last February and it appears that the macro side of the preferred share market has mostly normalized and accounted for the incredible drop of dividends on the 5-year rate reset shares due to the 5-year government bond rate plummeting (0.62% at present with short-term interest rate futures not projecting rate increases until at least 2018).

We are still seeing significant dividend decreases as rates continue to be reset.

I have looked at the universe of Canadian preferred shares (Scotiabank produces a relatively good automated screen) and further appreciation in capital is likely to be achieved through credit improvement (e.g. speculation that Bombardier will actually be able to generate cash indefinitely) concerns rather than overall compression in yields.

As such, one should most certainly not extrapolate the previous three months of performance into the future. Future returns are likely to primarily consist of yields as opposed to capital appreciation.

While investment in preferred shares, in most cases, is better than holding zero-yielding cash (in addition to dividends being tax-preferred), one can also speculate whether there will be some sort of credit crisis in the intermediate future that would cause yield spreads to widen again. If your financial crystal ball is able to give you such dates, you can continue picking up your quarterly dividends in front of the steamroller, but inevitably there will always be times where it is better to cash out and then re-invest when everything is trading at a (1%, 2%, 3%, etc.) higher yield.

I am also finding the same slim pickings in the Canadian debenture marketplace.

Valuations have turned into such that while I’m not rapidly hitting the sell button, I’m not adding anything either and will continue to collect cash yields until such a time one can re-deploy capital at a proper risk/reward ratio. If I do see continued compression on yields I will be much more prone to start raising significant fractions of cash again. Things are very different in 2016 compared to 2015 in this respect – in 2015 I averaged about 40% cash, while in 2016 I have deployed most of it.

A very quiet May and some self-reflection

It has been a relatively calm month of May for me – I know the cliche of sell in May and go away has resonated in my mind, but my positioning is still quite defensive (very heavily weighted in preferred shares and corporate debt). One advantage of such a defensive portfolio structure is that it is relatively insulated to equity volatility.

The past three months have seen quite a significant performance gain and when there are gains this large I always ask myself whether it is sustainable. When I look at the fixed income components of my portfolio, I see higher room for appreciation from current levels as markets continue to normalize. For whatever reason, Canadian markets were heavily sold off in early February, especially in the fixed income space, and we are still continuing to see a normalization of these valuations.

There were a few missed opportunities on the way. I will throw out a bone for the audience and mention I was willing to pounce on Rogers Sugar (TSX: RSI) when it was going to trade below $3.75/share, but clearly that did not happen (sadly, its low point was $3.84/share) and it has rocketed upwards nearly 50% to $5.71 presently on the pretense that Canadians are going to have a sweeter tooth for sugar rather than corn sweeteners in the upcoming months (which is true – their last quarterly financial statements show an uptick in business and this should continue for another year or so and the market has priced this in completely).

My overall thesis at this point is that the aggregate markets will be choppy – there will not be crashes or mega-rallies, but there will be lots of smaller gyrations up and down to encourage the financial press that the world will be ending or the next boom is starting. When looking at general volatility, the markets usually find something to panic about twice a year and we had a large panic last February. The upcoming panic would likely deal with the fallout concerning the presidential election.

If net returns from equity are going to be muted, it would suggest that the best choices still continues to be in fixed income. The opportunities at present are not giving nearly as much of a bang for the buck in terms of risk/reward, but there are still reasonable selections available in the market. A good example of this would be Pengrowth Energy debentures (TSX: PGF.DB.B) which is trading between 94 to 95 cents of par value. Barring crude oil crashing down to US$30/barrel again, it is very likely to mature at par on March 31, 2017. You’ll pick up a 6% capital gain over 10 months and also pick up some interest at a 6.25% coupon rate. Worst case scenario is they elect a share conversion, but with Seymour Schulich picking up a good-sized minority stake in the company, I very much doubt it. (Disclosure: I bought a bunch of them a couple months ago at lower prices).

In the meantime, I am once again twiddling my thumbs in this market.

Reviewing one of my year-end predictions

For my December 31, 2015 new year’s predictions, I said the following:

* Next US President: Donald Trump will be elected as the next president of the United States, by a considerable margin. This prediction is not an endorsement of him, but it is a reflection of my political analysis and my take on what is happening in the United States at present.

I’ve been telling people since September 2015 that Donald Trump would not only win the nomination, but the presidency of the United States. The general election result is not even going to be close – Trump will get at least 350 electoral votes.

What to do with profitable option positions

If you are in a fortunate situation where you bought out-of-the-money options and then the market moved favourably in your direction to the point where the value of the underlying is at your estimate of where it should be, what do you do with your existing option position? You would have made a small fortune and there are a few options:

1. Sell the option – you will probably pay a higher spread since it is in-the-money and will be receiving less time value;
2. Sell the common, and wait for the exercise – doing this will expose you to the downside below the strike price and also give up the time value of the option;
3. Sell the common, and exercise – doing this will give up the time value.

In most cases, the best option is #4: Sell an at-the-money option.

This maximizes the time value remaining in the option. There is still downside risk, but your in-the-money option’s time value will increase at it approaches the strike price, which acts as a weak hedge.

I generally do not play with options because they are incredibly inexpensive instruments to play with (mainly spreads, but they are also commission-heavy). The few times it makes sense is always when you are receiving good value for money – in the most recent case it was something trading at a far lower volatility than it should have combined with an obviously retail order on the ask that I just had to hit. The other instance was selling high-volatility puts in instances where things couldn’t get any lower. Sometimes those automated models do offer some free money when they do so without regard of the fundamentals of the underlying stock.

Financial crisis #2

The perverted effects of having a negative yield curve is finally hitting the financial markets. In particular, this is hitting the banking sector in Europe, but there is also spill-over effect in the USA as well – I had previously written about Bank of America, but this is also affecting other financial institutions.

However, I do have a general rule and that is whenever it hits the headlines of mainstream publications, it is likely closer to the 9th inning of the ballgame rather than the beginning.

I observe on the Drudge Report, which is usually ahead on things:

drudge

Once news like this starts getting on the covers of the various US magazines and such, then it is likely over.

Canadian publications are also picking up on the fact that the government bond yield curve is flat-to-inverting:

Target overnight rate: 0.5%
1 month: 0.43%
1 year: 0.42%
2 years: 0.35%
3 years: 0.35%
5 years: 0.48%
7 years: 0.79%
10 years: 1.01%

The half-point spread is a very pessimistic for the Canadian economy – people are willing to pay dearly for safety at the moment.

With government bond yields so low, investors must look elsewhere to obtain yield. This leads institutions into the wonderful world of corporate debt, and you can ask how the big 5 Canadian Banks (Royal, Scotia, CIBC, TD and BMO) are doing with all of their secured credit lines they’ve given to a lot of the oil and gas industry, in addition to their mortgage portfolios.

The Bank of Canada must be watching the sector like a hawk right now because if there is a cascade of confidence loss, things will get very ugly and very quickly. Conversely if this crisis starts to fade away, investors will be handsomely rewarded for taking the risk right now.

In the meantime, enjoy the volatility. The environment right now is once again reminding me of something like mid-2008 when everything is all panicky. Bargains that have good potential for double-digit appreciation are hitting the radar in huge frequency.

The biggest gainer on December 22 market trading

I will predict the company with a market capitalization of at least $1 billion that will exhibit the largest percentage increase in market valuation on December 22. I am pretty certain of my conviction.

Unfortunately, the company is not publicly traded. It is very likely to be publicly traded one day.

The company is called SpaceX, run by the same genius that runs Tesla Motors (Elon Musk).

Yesterday, they launched a rocket into space. They have done this before and being a private firm, this was no small feat as it was only done before by government-funded/operated space agencies.

The next step in their cost-optimization is being able to get the first stage rocket back to earth in one piece. Since the first stage probably costs around a low 3-digit million amount to construct, you would save a lot of money recovering this piece instead of having it dumped in the ocean.

They managed to do this less than 24 hours ago. Watching this video (the re-entry of the first stage rocket starts around 32 minutes in) is amazing. You can read about their initial attempts here.

My university degree was majoring in physics. I do not believe most people can appreciate how truly difficult this is to get correct.

They still have to figure out some other non-trivial matters, such as how much metal fatigue becomes a factor when reusing rockets, and how to deal with various atmospheric and variable factors that inevitably will come into play when it concerns rocketry, but for the most part, they are very well on their way to total domination of the low-cost space launch market.

After this successful re-entry, if SpaceX was publicly traded, I would guess their market capitalization would be up by 50% in a single day, which will likely top the charts on an ordinarily boring Christmas-time trading day.

The point of maximum fear

Very interesting things happens to markets at bottoms and tops – there are typically panic spikes down and up.

My market instincts suggest that we’re approaching some sort of local maximum for fear in terms of the energy markets. All doom and gloom, and usually you hear about the opposite arguments (demand is rising, geopolitical risk, etc, etc.) but none of this is present.

Probably a reasonable time to shop for assets in entities that will be able to survive the trough.