Tag Archives: seeking-alpha

Time To Short The VIX?

Summary Historically, we haven’t reached breakout status for the VIX. Many global factors are at play. This is possibly an economic event leading to longer periods of backwardation. The last week in volatility has been very exciting to say the least. The VIX Index logged the highest ever one week gain in percentage terms. Again, we immediately had the pundits out yelling short the VIX. I saw posts on Thursday around the web urging readers to short the VIX. Someday, this will end poorly for them and the people that heed their advice (Friday should have been a good sign). Below we will examine whether this really is a good opportunity to short in terms of risk verses reward. I am always analyzing my risk and reward in a trade. Once the reward begins to outweigh the risk, then I will begin planning my entrance. I believe risk and reward are currently the same. Essentially giving you a 50/50 chance of profiting right now. More to come on that later. Let’s start by reviewing the past month for the Proshares Ultra VIX Short-Term Futures ETF (NYSEARCA: UVXY ) and the VelocityShares Daily Inverse VIX Short-Term ETN (NASDAQ: XIV ). You can clearly see the effect of last week in the chart. Similarly here is a chart showing the front-month VIX futures contract. As you know (or should know), UVXY does not track the VIX Index, which is currently at 28. This is a large divergence from the front month futures contract. Remember futures trade independent of the market and the VIX Index. This, in my opinion, means that investors aren’t that concerned yet over a crash in the markets. U.S. economics continue to be neutral to positive. However, global economic fears are beginning to spillover. Just six months ago analysts were touting emerging markets, now look at them. For more on how UVXY profited during the 2008 and 2011 VIX events, check my library here on Seeking Alpha. UVXY will benefit from the current levels of backwardation if they can hold for a longer period of time. See below: (click to enlarge) Backwardation at 6.5% roughly means that UVXY will increase 13% in one month’s time if futures stay the exact same price, minus any fund fees. Now we know futures never stay the same, but this is just an easier way to think about contango and backwardation. Backwardation hit over 20% in 2011 and over 40% in 2008 (backtested). Backwardation is the only way UVXY will hold profits over longer periods of time. Again, check my library for articles on backwardation if you are unfamiliar with the term. Historical Numbers I know many of you are very excited about this spike. However, let’s compare this event to past events. Backwardation: (click to enlarge) At 6.5%, this puts backwardation higher than a normal political event. If you remember in my last article we discussed the differences between an economic and political event. This event, so far, is leaning towards an economic event. Economic events are usually much more drawn out. I told you earlier in the year I was looking for a backwardation event higher than 10%. I believe this could become that event. More about this in the conclusion. Futures Levels Futures levels directly impact UVXY. Here is a longer-term chart of those futures levels: Yes, futures are towards the higher end of what they have been over the past three years. However, this is nowhere near breakout status. Futures generally trade lower than the VIX Index during a spike. For reference however, here is the VIX Index dating back to 1990: Conclusion The best entry points in the VIX futures, for shorting UVXY or going long XIV, occur during periods of prolonged economic turmoil. Yes, we logged the highest ever one week rise (by percentage) in the VIX Index. However, I feel we still have room to rise. Those pundits that are shouting short the VIX may be right or may be wrong, that is not the point of this article. I like a lot of reward for the risk I am taking. I don’t see the VIX returning to 12 anytime soon. We are in a prolonged period of slower economic growth. Eventually that was going to catch up to valuations and the U.S. stock market. We have recessions in Brazil and Chile. We have slowing growth in China, which should be your biggest concern. The Greek drama is off the table for now but you still have a case of many countries within the Euro that have very high debt levels and growth that isn’t high enough to sustain it. Here in the U.S. we also have unsustainable debt levels but can print however much money we desire. Ultra low rates have helped lower the burden of interest payments but the lack of decent inflation has backed The Fed into a corner in regards to raising rates. A September rate hike would spook the markets. The fact we don’t see higher inflation even given the ultra low interest rates is a realization and confirmation of the slow growth era. For now, I will remain on the sidelines and hope conditions continue to worsen. If I miss the opportunity, I am certainly okay with that. My total VIX portfolio is up a healthy amount YTD and I am fine with locking in those gains instead of gambling it away. This is not to say that I am not salivating at the mouth for a chance to short the VIX. Here is what I am currently watching, in order of importance: The Fed (what’s going to happen with rates, I view any delay as a negative confirmation on the U.S. economy) Economic data out of China (can the government stop the decline this time?) U.S. employment data (weekly) Devaluation of the Yuan (will it continue?) Economics in South America Political/debt situation in Europe (Greece drama is on the back burner for now) I am not backing up the truck to short this spike. We may get a bounce in the U.S. next week but economic problems always take a while to resolve themselves. I would short the VIX with caution if you feel that is the right thing to do. Call spreads (more info on my blog), stop losses, and not jumping all in help to limit your risk/reward. Risk management is needed here, otherwise you are just gambling. I wish you the best this week and know that I will be following the situation and posting updates when needed. It will be an interesting week! Should conditions deteriorate even more, I might begin shopping for a small position. With school starting, I would only be looking for a more long-term position since I am busy during the day. I just need more reward for the current level of risk. Donate to my classroom! I am trying to create a 360 degree mathematics classroom. Much of the money I make here on Seeking Alpha is donated back into public education, something I really believe in. My students come from the highest area of poverty where I live. They are truly great students with a desire to better themselves. My job is to level the playing field and give them a chance to succeed. One tool I used last year at a different school was a 360 degree mathematics classroom. It is a great tool for math teachers. A lot of what I teach lays the foundation for financial literacy and success in post-secondary education. Here is the link if you would like to help fund my 360 degree boards. Use the code SPARK at checkout (until 8/27) and your donation will be matched 100% up to $100. Currently they are running another promotion from The Gates Foundation that will also match 100% up to $1,000 (which would be more than what is needed). That code is JUMPSTART but will only be available for a limited time. You can’t use both codes. All donations are tax deductible and will make an actual difference in the education of some great kids. We are getting close to funding. Thank you! Disclosure: I/we have no positions in any stocks mentioned, but may initiate a short position in UVXY over the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

A Conservative Tactical Momentum Strategy Using Bond ETFs

Summary A simple tactical asset allocation strategy is described that selects one ETF each month from a basket of 5 essentially non-correlated bond ETFs. 4-month and 2-month returns are used to determine the top-ranked ETF each month. The backtest results of the strategy (1998 – present) using mutual fund proxies for the ETFs indicate a CAGR of 14.8% and a maximum monthly drawdown of -10.7%. There are no negative annual returns even in 2001, 2002 and 2008. Any investor can easily set up and trade the strategy using the free Portfolio Visualizer software. In the current market turmoil, many investors are looking for a more conservative bond strategy to reduce risk. In this article, I present a new bond tactical asset allocation strategy that is relatively simple and may be attractive to such investors. One of the obstacles in developing a tactical bond strategy is the short history of bond ETFs. This allows rather limited backtesting of bond ETFs. In order to extend the backtesting timeframe, mutual funds that have longer histories are selected as proxies to the ETFs. The proxy mutual funds are selected based on correlation and performance with their ETF counterparts. The strategy was developed using the free Portfolio Visualizer (PV) software. I first selected bond assets that were relatively non-correlated to each other. Shown below is the basket of assets I decided to use; the basket is similar to the basket used by Frank Grossmann in his “Bond Rotation ‘Sleep Well’ Strategy.” I have listed the ETFs followed by its mutual fund proxy and the average correlation coefficient between ETF and mutual fund proxy. Convertible Bonds: SPDR Barclays Capital Convertible Bond ETF ( CWB) – I nvesco Convertible Securities Fund ( CNSAX) (Correlation = 0.84) High Yield Bonds: SPDR Barclays Capital High Yield Bond ETF ( JNK) – Fidelity Advisor High Income Advantage Fund ( FAHDX) (Correlation = 0.63) Long Term Treasury: iShares 20+ Year Treasury Bond ETF ( TLT) – Vanguard Long Term Treasury Fund ( VUSTX) (Correlation = 0.98) Short Term Treasury: iShares 1-3 Year Treasury Bond ETF ( SHY) – Vanguard Short Term Treasury Fund ( VFISX) (Correlation = 0.80) Emerging Market Bonds: PowerShares Emerging Markets Sovereign Debt Portfolio ETF ( PCY) – T. Rowe Price Emerging Markets Bond Fund ( PREMX) (Correlation = 0.40) PREMX is the only proxy that has somewhat poor correlation to its ETF cousin PCY, but it was the best I could do. A chart from Stockcharts that presents the performance of PCY and PREMX is shown below. The chart shows that PREMX is a reasonable proxy for PCY. (click to enlarge) Asset correlation coefficients for the mutual funds for 07/28/1997 – 08/18/2015 based on daily returns are shown below. The correlation coefficients from PV are the overall coefficients over the entire backtest period. The mutual funds are generally non-correlated or negatively correlated, although a few of the correlations are greater than what I wanted. (click to enlarge) I selected the top-ranked fund each month based on relative strength returns of four months and two months. The overall rankings were based on a weighting of 51% on the four-month rankings and 49% on the two-month rankings. The results taken from PV in tabular form and graphical form (with permission) are shown below. This strategy has a CAGR of 14.8% and a maximum monthly drawdown of -10.7%. This compares to a CAGR of 6.5% and a maximum monthly drawdown of -51% for the S&P 500. It would have been better to use a bond-based fund instead of the S&P 500 as a benchmark, but that option was not available in PV. (click to enlarge) (click to enlarge) There are no negative return years; the worst year is 2001 with a return of +1.5%. The annual returns each year are shown in the table below. The final step in backtesting this strategy is to compare the results of the ETFs with the results of the mutual funds from 2010 – present. The 2010 start date was dictated by the origin of the youngest ETF in the basket. The results for the ETFs and the mutual funds are shown below. The ETFs give similar results as the mutual funds. ETF results (2010-present): (click to enlarge) (click to enlarge) Mutual fund results (2010-present): (click to enlarge) (click to enlarge) The same strategy using the ETFs was executed with the commercial ETFreplay software. The results are shown below. The ETFreplay results were comparable to the PV results, but the ETFreplay results did not exactly replicate the PV results. The CAGR is 15.8% for ETFreplay and 17.4% for PV from 2010 – present. The maximum daily drawdown in the ETFreplay trading scheme is – 10.9%. The maximum monthly drawdown using PV is -6.1%. (A monthly drawdown calculation will always be better than a daily drawdown calculation.) These differences between ETFreplay and PV are primarily caused by ETFreplay using trading days to calculate returns while PV uses calendar months. Also, the data sources may not be the same. (click to enlarge) Another option with this strategy is to select two funds each month instead of only one fund. As would be expected, the performance is reduced, and the risk is improved (i.e. lower drawdown). In the two-fund scenario from 1998 – present using PV, the CAGR is 12.5% and the maximum monthly drawdown is -7.0%. The two-fund scheme also has positive returns every year. Any investor can go to the PV website and run these calculations and determine the monthly ETF selection at no cost. This momentum strategy seems to have potential as a conservative investment strategy based on backtesting to 1998, with the usual caveat that the strategy depends on how faithful the mutual fund proxies mirror their ETF counterparts. Please use this strategy at your own risk. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

MLP Screening – Did The Market Overreact To Some 10%+ Yielding MLPs And Should We Value Them Differently?

Summary MLPs have held up relatively well against the commodity price decline until it recently plunged ~20% in the last 3 months. Alerian MLP ETF currently yields 8.5% with a select number of names trading well above 10% distribution yield. MLPs have largely been safe yield vehicles – will there be a shift in investor base and change in how investors value MLPs? Disclaimer: For avoidance of doubt, any reference to MLP excludes E&P MLPs for the purpose of this article. Alerian MLP Index (AMZ) Price Performance (click to enlarge) Alerian MLP Index Yield vs. Other Indices (click to enlarge) MLPs have been an efficient route for midstream asset owners to monetize their stake in assets that have largely contracted or recurring cash flow characteristics at valuations that far exceed private transaction multiples. For investors, it has been a very attractive/safe yield vehicle (and tax friendly) underpinned by a consistent and high growth profile as billions of new capital got deployed for new drilling and infrastructure developments. At a very high level, most MLPs service the upstream and/or downstream value chain in providing long-term recurring services. A recurring revenue stream ensures stable cash flow and given that 90% of distributable cash flows are required to be distributed in order to maintain MLP classification, investors enjoyed stable cash yield. Continued expansion of infrastructure and oil & gas exploration activities also led to high-single digit to double-digit growth in distribution. As a result, distribution yield (with growth embedded) kept falling and valuations kept going up. MLPs were also able to grow through acquisitions, using its extremely cheap cost of capital to acquire businesses at high multiples, which were still accretive from a distributable cash flow (“DCF”) point of view. While investors can view MLP businesses using more traditional valuation metrics such as EV/EBITDA and P/E, in real life, and in a grossly oversimplified form, valuations are quoted based on distribution yield. Again, in a very simplified manner, if you were to dissect distribution yield, the market essentially assigns a cost of equity (what level of levered cash flow the business should generate in perpetuity) and subtracts a growth rate on the DCF – and this dictates the distribution yield that the market bases its valuation/stock pricing for that particular MLP company. Let’s dig a little deeper in terms of this valuation concept. This was a perfectly feasible method of valuation for a number of reasons. 1) DCF for an MLP is actually very predictable and stable (EBITDA – maintenance CapEx – interest expense was very stable), 2) because it is very predictable and MLPs are required to distribute that DCF to investors, it made even more sense to value the business from a DCF/distribution perspective, 3) growth through backlog and continued capital spend in the broader oil & gas industry was also very visible and the implied valuation derived from a yield (or multiples if you invert the yield) standpoint was far in excess of general market valuation, and therefore, using EV/EBITDA or P/E where the general market trades at ~9-10x EBITDA and ~16-18x earnings obviates any sense of comparability. Said in a different way, DCF growth rate is what moved the needle from a valuation standpoint and was therefore the most important variable in determining how the stock price would move. To avoid any psychological biases, let’s remove the “MLP” classification for a second and just consider them as a normal c-corp business. Also, let’s work under the premise that there is no debate around the fact that the commodity price environment is challenging and there are lots of uncertainties and macro headwind pervading the market. For simplicity, let’s take out the near-term growth component and say there is no growth for the next year or two. Even without growth prospects, these are excellent businesses with contracted/recurring cash flows, minimal capital requirement to maintain earnings power, and minimal operational complications (often times there are pricing protection through contracts and even annual CPI escalators). How much would you pay for this type of business? Maybe there will be a slight dent in EBITDA this year or next year (not many names are really taking a hit on cash flow, they are just growing at a slower rate), but if the premise is that there is always cyclicality in the commodity market and things will turnaround to get back into a nice growth trajectory in a year or two from now, how much would you pay off next year or two-year forward FCF? To take a more draconian stance, even if there was no growth trajectory in a year or two from now, is it truly justifiable to say that many of these businesses should trade at 500-1000bps above debt instruments with equivalent credit ratings? When was the last time you were able to pick up a stock for 4-9x levered free cash flow even if there was a dim outlook for businesses that possess this quality? For the purpose of identifying “better” quality – off the top of my head, few high level components to look for in terms of evaluating the fundamentals of these businesses: 1) Contract structure (duration, minimum volume commitment, take-or-pay % vs. throughput %, fixed fee vs. commodity price dependent fee, inflation escalator); 2) Customer credit (liquidity, credit ratings, leverage), types of customers (E&P, refinery, other midstream, logistics, export demand, etc), customer diversity (having customer concentration through an excellent customer may sometimes be more favorable than having mediocre quality diversified customer base); 3) Liquidity (cash + RCF availability); 4) Geography (if volumes are growing at a certain geography or basin, it doesn’t matter if commodity prices are falling for the midstream provider); 5) Maintenance capital as % of EBITDA; 6) Growth capital need and payback period (some businesses like a pipeline are capital intensive in the beginning but it’s all about maintaining existing volume and increasing utilization whereas some businesses require continued capital spend to service both existing and additional customers; it’s a tough dynamic if you are in a spot today where you are asked to spend capital in hopes that you will utilize them in the future) While there was always some level of premium/discount for MLPs depending on sub-sector, commodity price exposure, contractual structure, maintenance/growth capital need to maintain cash flow profile, geographic footprint and size consideration, today’s market where many players are trading at yields that imply distribution cut and at a meaningfully compressed valuation relative to few months ago and versus the broader market, it definitely seems like an interesting environment where MLPs are interesting not just as a safe haven and perpetual dividend asset but an opportunity to generate alpha through capital appreciation. During this oil crash since summer of 2014, you have consistently seen sub-sectors get crushed, only to see a lagged pick up among “better quality” names (E&P, OFS, LNG, Petchems, etc). This sequence of overreaction immediately followed by a quick and steep rebound among quality names is common across all sectors during a market sell-off. While this article does not address a specific recommendation and may be repeating what is already well recognized among investors, I wanted to provide 1) a quick screening of MLP names that are under oversold categories and 2) perhaps a different perspective around decoupling from the prevalent methodology of looking at MLPs like a fixed income security to a more traditional equity security (especially in light of what the valuations imply at today’s price and for those who think investing in MLPs today is like catching a falling knife). Below is a quick screening based on MLPs trading above 10% 2015E distribution yield (I am sure I am missing a few names that have above 10% yields). Second table excludes names with net debt/’15E EBITDA above 5x. There is not much science for drawing the line at 5x but wanted to exclude names that may be trading at compressed valuations due to distress and/or were previously highly levered to rapid growth prospects. Again, I have no idea if the excluded names are truly in distress or sized debt prematurely with too much embedded growth – just wanted to make the bifurcation. MLP Universe (NYSEARCA: AMLP ) – Names trading above 10% distribution yield Source: Capital IQ – Crestwood Midstream (NYSE: CMLP ), Crestwood Equity (NYSE: CEQP ), Southcross Energy (NYSE: SXE ), Azure Midstream (NYSE: AZUR ), Hi-Crush (NYSE: HCLP ), Natural Resource Partners (NYSE: NRP ), CSI Compressco (NASDAQ: CCLP ), Cypress Energy (NYSE: CELP ), American Midstream (NYSE: AMID ), Teekay Offshore (NYSE: TOO ), Capital Product Partners (NASDAQ: CPLP ), Midcoast Energy (NYSE: MEP ), Martin Midstream (NASDAQ: MMLP ), Exterran Partners (NASDAQ: EXLP ), Targa Resources (NYSE: NGLS ), DCP Midstream (NYSE: DPM ), USA Compression (NYSE: USAC ), Teekay LNG (NYSE: TGP ), NGL Energy (NYSE: NGL ), Oneok Partners (NYSE: OKS ), Suburban Propane (NYSE: SPH ). MLP Universe – Names trading above 10% distribution yield and less than 5.0x net debt / ’15E EBITDA Source: Capital IQ – Crestwood Midstream, Crestwood Equity, Azure Midstream, Hi-Crush , CSI Compressco, Cypress Energy, Teekay Offshore, Capital Product Partners, Martin Midstream, Exterran Partners, Targa Resources, DCP Midstream, Oneok Partner , Suburban Propane. Disclosure: I am/we are long CELP. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.