Author: Sacha Peter

Dysfunctional trading algorithms

The algorithms that dictate the trading in the marketplace (there are very few human beings intraday that are actually trading stock anymore) are causing very weird gyrations.

In the case of Yellow Pages (TSX: Y) (yes, if you didn’t get stopped out of this company, you will be making money after this CoronaPanic is over with), it went from $8 to $9.20 with a trigger of about a thousand shares.

This can only be described as dysfunctional algorithmic trading – some machine that was ordered to accumulate at any cost, and little in the way of supply between $8 to $9.20. After that was hit, another algorithm somewhere else was activated that employed some sort of “regression to the mean”, or perhaps Yellow then became the desired choice for a liquidation, or who knows.

But either way, you can take advantage of these dysfunctional algorithms by paying attention – selling when the buying is “stupid”, and buying when the selling is “stupid”.

With thinly traded stocks, always keep in mind that trade prices are done at the margins. Trades that are forced always create the most potential for price dislocation, especially for thinner traded securities.

CoronaPanic, edition 5 – random thoughts

Alpha Pro Tech (APT on the NYSE), my proxy for the CoronaPanic, is up 3%, while the S&P 500 is up 3.5% compared to yesterday’s slaughter.

My guess is that this is, with respect to the markets, 80%-90% over, but noting the actual spread counts in the USA/Canada are probably 20% done. Please note I’ve been badly wrong on my timing during this whole panic so take any predictions with a grain of salt, and they change with incoming information. There will be serious damage in terms of supply chains, and GDP to tourism and public-crowd related events (the cruise ship industry is toast, and anything relying on a shopping mall or foot traffic for discretionary consumer sales, e.g. clothing retailers, is in big, big trouble – thinking about TLRD here). On the flip side, Dollarama (TSX: DOL) is a great place to buy cheap panic supplies!

Companies that are close to debt covenants will likely tip over and when the banks come calling, it will not be pretty, but just for them and the financials. Certain corporate debt issuers look very interesting, spreads are hugely wide.

The infected accumulation curve will increase quite rapidly in the USA, and Canada. That said, the new phraseology of “social distancing” will stick and people will discover new-found time at home.

China, Hong Kong, Taiwan, Japan, South Korea, and even places that you don’t ordinarily associate with public cleanliness (Thailand, Malaysia) have it under control. Even if you don’t believe the stats coming out of China (which you shouldn’t, ever), the other countries do have reporting mechanisms that are relatively more trustable. In particular, SARS taught anybody coming out of Hong Kong about how to react and behave. This culture will come to North America and in the longer run, will improve our society.

Nobody seems to be talking about climate change anymore. I wonder why!

The media will hype this up to the point of being one of those “outbreak” movies, with the reality being somewhat more muted, which is:
* around 80% of the people that catch Covid-19 don’t get any symptoms at all
* those that are seriously affected or die from it are older (65+) people prone to other conditions (heart, lung)

The governments are in a ‘stuck’ position, mainly if they panic too much, they look stupid, while if they don’t panic enough, they will be accused of not panicking enough. They’re stuck in a rock and a hard place, but the Government of British Columbia has struck a very nice balance between these two.

There might even be a cultural change where telecommuting may be even more acceptable than it is at present. This has been going on at a snail’s pace, but Coronavirus will accelerate it. Will office REITs be killed?

Netflix, Amazon Prime Video, Hulu will receive record subscriptions; internet providers are going to deliver record amount of bandwidth.

There will be a considerable element of demand destruction in North America over the next month, but after that, things should normalize. Fundamentally, life continues, and pension funds need to make their returns. The character of the returns, however, will be somewhat different because interest rates are once again at the zero boundary. There will be a drive to TINA – There is No Alternative, which means that the drive for yield will be very alluring. You can’t invest in bonds (zero return, or you’ll probably get a 2-3% spread on BBB-A type issuers), so equity will be the only game in town (once again).

Gold, the last safe haven, people are still discovering like preferred shares and bonds, that it is not immune – right now gold is being sold to raise cash to buy other “risk-on” assets, but once the Federal Reserve and other central banks polish off their 2008 game plans and re-execute it, the currency depreciation should flow into commodities in a dramatic fashion – this will include gold to a degree.

Another question is what happens with inflation. Right now with the demand destruction and possible collapse of debts by companies that were already teetering on the brink – this will likely cause a drop in CPI. But I’m wondering about the rebound effect – once that has all been dealt with over the next 12 months, will there be a shortage of goods/services available relative to the money supply? Will we be seeing a huge rebound in consumer costs circa 2021-2022? Just a thought.

Finally, the US and Canadian governments are going to blow deficits like you’ve never seen before. I’m expecting Canada to announce a $60 billion dollar deficit for the upcoming fiscal year. The US will probably blow a couple trillion dollars. They can do so, and have the financial capacity (interest rates are at zero, after all).

Where does all of this fiscal stimulus go? In an idea world, public infrastructure – stuff that will be actually useful and consume domestic goods and services. The question is whether it actually does so or not. But the underlying point here is that companies that have relatively large amounts of revenues from government sources – they will likely do well. Engineering firms, defense, etc.

In particular I’ll disclose a holding in BWX Technologies (BWXT on the NYSE) which specializes in nuclear engineering in defence and civilian fields. This position was acquired within the last week. While it has not been taken down nearly as much as most of the rest of the stock market, I am pretty sure this company will be higher in a year.

I have also taken a long position on the S&P 500 futures at the close of March 12, 2020, which was at 2475. Equity liquidity will reign, and nothing will be receiving liquidity more than the Apples, Microsofts, Amazons, etc., of the US universe. My price target is 3100. This is in absence of having conviction on anything other than a few select names of reasonably credible companies (e.g. BWXT) that I’ve done a ton of due diligence on prior to this crash.

Companies that can collect cash and nowhere close to any credit covenants/maturities are critical variables at this point.

Volatility spike

TSX down 12%, S&P down 9.5%, and VIX reached 75 today, holy crap:

This is not predictive, but it is at the level that was experienced during the 2008-2009 financial crisis:

Again, VIX is not predictive, but suffice to say this is one of those “six sigma” events that are supposed to happen once in a million years, but instead takes 12 years apart to realize. Who knows, it might head to 100.

Just as a reminder, VIX is a measurement of what traders expect is the annualized implied volatility of the S&P 500 over an average of 30 days. The word “volatility” in everyday language implies down, but mathematically it implies movement in either direction.

Dividend cuts

Those cash-flowing equities with yields are going to cut dividends simply because there’s no other outlet. If you’re depending on a stock for their yield, one must have a good grip on whether they can sustain it from a balance sheet perspective.

I won’t even cover the oil and gas sector – those that had dividends will surely lower or eliminate them (SU and CNQ may be exceptions here, but everybody else – good luck!). In Canada, nobody will make money with WCS at US$20/barrel. Interestingly enough, in the gas world, AECO/Dawn/Henry Hub are holding steady.

Chemtrade Logistics (TSX: CHE.UN) announced they are dropping their distribution from $1.20 to $0.60/unit per year. This wasn’t surprising to me since even at the current rate they are still questionable.

Melcor (TSX: MRD) decreased their quarterly payment from $0.12 to $0.10/share; as their property portfolio is entirely Alberta-centric they are secondary roadkill in the oil/gas slaughter.

Anything in the equity markets that are trading at double-digit yields – give the balance sheets a very careful look, and ask whether the cash flow, accounting for a decrease in the economic landscape, will be able to provide sufficient coverage.

There will be a few equities with double digit yields that will recover and maintain their dividends, but it will be few and far between. However, if you do manage to snag them, and the overall economy recovers, you will be the recipient of a yield compression and continue receiving distributions at your original (low) cost basis. High risk, high reward.

Canadian Preferred shares are getting killed

The rest of the stock market is getting killed by the Coronavirus as well, but Canadian preferred shares are not much of an escape valve.

James Hymas reported today that:

It is noteworthy that the Total Return version of TXPR closed at 1,304.43 today. I will note that the value of this index on September 30, 2010 was 1320.92, so total return has been negative over the past NINE YEARS AND FIVE MONTHS and a little bit. That’s before fees and expenses. Remember those charts I published in the post MAPF Performance : August 2019 illustrating the downturn to date, comparing it to the Credit Crunch and remarking that there had been zero total return for seven years and four months? Well, those charts are now out of date.

The two major ETFs which trade in Canadian preferred shares are ZPR and CPD, and they both have been murdered in the past two weeks, roughly 17%:

A negative total return of 9 years and 5 months can be contrasted against the TSX total return of about +4.5% (compounded annually) in the same period. In theory, preferred shares are safer investment vehicles than common shares, but clearly as the 5-year rate reset preferred share came to dominate the market, as 5-year interest rates have declined, they have also taken down the capital return of the preferred shares, resulting in very lacklustre long term performance.

This can only be considered to be a total washout that is going on.

One reason is perhaps that leveraged players are being forced to cash out. A retail example is in this reddit post, where the poster very thoughtfully constructed a diversified portfolio of preferred shares, and who is certainly underwater on this trade.

The math was pretty simple: Choose a “stable” preferred share (e.g. BAM.PR.Z) (4.7% and a rate reset of 5yr+2.96%, which presumably would be ‘stable’ since obviously the five year government bond will hover near 1.7% and you won’t get ripped off on the rate reset!). You borrow money at 3.3% from a proper brokerage firm, and leverage $100k of equity to buy $200k of stock, and voila. At the beginning of 2020, the shares would yield 5.9%, and your net would be 2.6%, minting a cool tax-preferred $2,600 in the process per $100k equity.

The problem is today, those BAM.PR.Z shares are worth $160,000, your net equity is down to $59,175 (had to pay the interest expense) and the only thing you will be receiving in this procedure is a first dividend payment of $2,928 tomorrow (which will correspond with a drop in the price of the preferred shares, so this is a push). Your margin level has gone from 50% to 37%, and this is precariously close to the 30% level which is allowed by the IIROC list of securities eligible for reduced margin and the brokerage firm.

Surely these preferred shares couldn’t go down further, to the point where you’re going to be forced to clear out your account? Can you take the risk being so close to the brink of a margin call?

This is part of what is going on. The other aspect is that the market is pricing in the reduced dividend rate that will inevitably occur with the rate reset. At a 5 year government of Canada bond rate of 0.55%, that BAM.PR.Z yield, after the reset, will go from 5.9% to 4.4% on original cost, which cuts heavily into the original intention of the trade, which was to skim a leveraged return off the dividend. The only solace is that the short term interest rate (that you would pay for margin) also decreases, but then your capital is impaired – you can realize the capital loss today, or wait patiently and hope for better times and hope things don’t get worse to where you will face that margin call.

These two factors I suspect are driving the push down in preferred shares. What will be even more fascinating is if we enter into a negative yield environment – preferred shares will look even uglier then.

Even the preferred shares with minimum rate guarantees (e.g. TRP.PR.J – 5.5%, reset at 4.69% with a minimum of 550bps) have not been immune to selling – although you are guaranteed a 5.5% coupon payment (and traded at a 4% premium to par for this minimum rate privilege to yield 5.3%), this series has been sold down in the past few weeks to 91.5 cents of par, or a minimum yield of 6.01%. Fascinating times.

Fortunately a couple weeks ago I sold all of my preferred shares short of a 2% position in something which I’m still not happy at myself for not unloading when I saw the proper bid for it.

Finally, the only solace for the rate reset preferred shares that are resetting at the end of March is that five years ago, the five-year government bond rate was 0.93%. I bet the people receiving that rate never thought they’d be getting a lower rate at the end of this month.