Category: Finance

A week ago I posted this speculation:

Today, it’s basically a continuation of this. My guess is that there will be a “flush”, a pretty significant one under that red line, will occur (let’s say to around 9800-9900). Especially in light of the president election dominating the course of the next couple months, prepare for a wild ride!

Again, a caution: this post is purely for entertainment value. My capital is far from these high-flyers that dominate the index (in rank order, Apple, Microsoft, Amazon, Facebook, Tesla, Google, Nvidia, Adobe, Paypal, Netflix).

BMO and its advisors are getting sued by clients. In the article, it claims the advisor in question in 2017 and the first half of 2018 traded on behalf of clients a leveraged short treasury, long preferred share strategy.

Both client groups allege that throughout 2017 and the first half of 2018, Mr. Liu recommended a new investment strategy that “assured safety” of their principal and provided “reasonable” investment returns.

Shortly after, clients allege they were instead placed in a high-risk strategy that involved short-selling bonds – particularly Canadian government bonds – to purchase long positions in preferred shares, many of which had variable rates or rates that reset based on interest rate movement.

According to court documents, Mr. Liu further advised the clients to begin trading on margin – investing using borrowed money – in order to purchase a larger amount of preferred shares. In some instances, clients allege Mr. Liu engaged in this strategy without informing them or seeking their permission.

I’d love to read the court documents.

I’m guessing the pitch was that you could borrow around 1.5-2.0% (short treasuries) and re-invest the proceeds in (relatively high quality rate reset) preferred shares yielding around 5-5.5%. Just throw in some cash and we can leverage this thing 5:1 and earn you a cool 15% return on equity. Sounds great!

Canada’s 5 year bonds in the first half of 2017 spent most of their time around 100-125bps, and the second half around 150-175bps. In the first half of 2018, they were at 200-225bps. So this pair of the trade would have surely lost money, but it would have been more than offset by appreciation of the preferred shares. In fact, during 2017, the trade would have looked really good and I would not be shocked if clients added more money to it:

The second leg of the trade (preferred shares) didn’t do that badly until about the fourth quarter of 2018, where preferred shares lost about 15% of their capital value. The bonds during this time would have appreciated somewhat, but depending on the amount of leverage employed, the trade would have been a significantly losing one. By the third quarter of 2019, the preferred shares would have declined another 10%.

I’m guessing it would have been after the 4th quarter in 2018 that clients came asking why they were seeing negative returns in their accounts. “Oh, don’t worry, these are normal market fluctuations, just look at the yields you’re getting!”. By the time the third quarter in 2019 came along, it looks like client losses would have been another 10% times whatever leverage factor they engaged in.

Back in June 2019 I mused about this, but it looks like others actually engaged in this trade, which is a classic example of leveraged yield chasing! It rarely ends up well unless if you close out the trade when you least want to – when the trade is working.

Here is a classic “trap” situation for market participants, especially those that follow technical analysis. I personally think technical analysis is nearly useless, except for the fact that other people find value in it, which means that the TA playbook can be used against other participants. Here is what I think is going on, although this is about as much speculative quackery as the analysis of charts, and thus I suggest treating this post as entertainment value only:

Blue lines: So what’s happening is you see the trendline is broken – technical analysis 101 recommends bailing out once the trendline is broken and shorting.

Red lines: This is a classic “descending triangle” situation, where the Nasdaq is attempting to hold support at the 10,800 level. TA 101 says once this support line is broken, that things are going to sour.

Green line: All of these retail investors at this point, with their “education”, will decide this is the point to capitulate and sell out their technology holdings because clearly things are going down. And indeed, it will be for a little bit as they bail en masse.

Except it will stop and rebound and confuse the crap out of everybody that has taken their chart-reading education.

Probably due to Robinhood, retail investors are getting into the business of option selling. Almost nobody in the retail scope should be doing this. The new professed method to riches has been selling put spreads (likely due to the fact that margin requirements for spreads are lower than flat-out selling naked puts). Robinhood loves people engaging in these strategies since they make far more per trade. Put spread selling appears to have been, at least to the end of August, a viable manner of making untold amounts of gains as they are the recipient of both price appreciation and time decay (theta).

In fact, since early June, it would have been near-impossible to lose money employing such a strategy, which is why in the month of August, you probably had hordes of people self-educating each other on the virtues of selling put spreads for a limited risk method to making free money. Free money!

The issue with put selling is that when it works you make a little (especially in relation to what you could have made had you just bought the common stock directly), but when the trade goes against you, you lose a ton of money. Many retail investors fail to calculate their risk exposure, especially in market environments in the past few days where not only do you lose on price (the delta skyrockets) but also volatility (which inflates the price of a short position and makes it much more expensive to cover).

Now the tide has turned and people are finally seeing that such strategies can make a thousand dollars a week, but lose you ten grand in a day when you bet incorrectly.

Just reading the reddit group /r/thetagang, it’s pretty apparent that a lot of people viewed this as a low-capital perpetual money making machine, at least until now. The quantitative algorithms that take the other side of these option trades, for the most part, have basically won to a degree more than one would at a casino playing a reasonably fair game of blackjack.

Wow, that was quick.

I said less than two weeks ago:

One major event that will occur in the future (a matter of when, not if) will be a significant power grid failure that will have been instigated by having too much intermittent energy sources on the grid, without available backup from domestic or external grid sources. This may be caused by a freak transmission failure (cutting an intermittent-heavy grid from a dispatch-able heavy grid) or some other ‘black swan’ event. When this occurs, there will likely be a dramatic shift in power generation policy to increase the robustness of a domestic power grid.

And what did we get last Saturday? Headlines such as:

(August 14, 2020) * Stage 3 Emergency Declared; rotating power outages have been initiated to maintain grid stability
(August 15, 2020) ISO Requested Power Outages following Stage 3 Emergency Declaration; System Now Being Restored
(August 16, 2020) Flex Alert Issued for Next Four Days, Calling for Statewide Conservation

What happened?

Excuse my crappy handwriting, but I had to illustrate this. Factors:

1. Wind dies down (can’t predict the wind very well, so you have no idea what your future supply is going to be);
2. Solar gets interrupted during the peak of the afternoon due to clouds;
3. Natural gas supply is down due to plant shutdown;
4. Cannot import (other grids are facing similar demand/supply issues).
5. Record-high daytime temperatures (e.g. Riverside, CA which is a suburb about 80km east of Los Angeles, at daytime highs of 40 degrees C), which causes huge demand for air conditioning.

What do you get? Rotating blackouts.

While I wouldn’t call this a “major event”, the fact that a major jurisdiction can’t keep the lights on speaks volumes.

This issue isn’t solved by adding renewables onto the grid – indeed, having too many renewables on the grid with the lack of dispatchable power sources was the cause of the problem.

If my suspicion is correct, this is going to be the start of a paradigm shift on what was a dead power production market (ruined by floods of cheap capital for intermittent power sources). I can’t tell whether this comes in the form of further power price increases (see: California, Ontario, Germany, etc.), increases in dispatchable energy supply (read: natural gas, nuclear or thermal coal!), or energy restriction mandates (or a combination of all), but either way, there are obvious investment angles coming down the line.

My only other comment is there are operational implications when you allow your quasi “crown corporation” primary power supplier PG&E (NYSE: PCG) to be sued into bankruptcy due to wildfire transmission line risk – when you get into situations like this weekend, it is obvious they will be shutting down transmission grids which reduces the robustness of a power grid since they don’t want to get sued to death again in case a spark catches fire somewhere. I wonder when they will get sued for constructive negligence because they shut down transmission lines and caused a huge cascade power failure which caused even more economic damage. Companies that operate under heavy regulatory coverage in California live and die at the behest of the state – watch out if you’ve got capital in PCG equity!