Friday, May 1, 2009

Understanding the VIX Model Better/Equity Preferred Stocks as a Disfavored Sub-Asset Class/Advanced Bond Yield Calculation: I do it my way

ADDED 5/19/2009: Some new readers are coming to this post.  The VIX Model is explained simply in this subsequent post:Vix Asset Allocation Model Explained Simply With as Few Words as Possible
There is a Gateway Post that contains links to other posts on this subject: USING THE VIX MODEL AS A TIMING INDICATOR FOR LONGER TERM STOCK ALLOCATIONS
Other posts that may be of interest relate to the signals given by the Model in 2007: 
A few of the other major posts include:
***********************original post

One of the posts that I wrote due to interest shown in the FEEDJIT widget involved my VIX asset allocation model.  I changed the heading this morning on it to just say VIX Asset Allocation Models and to delete the verbiage unconnected with the main topic of that post. VIX Asset Allocation Models
I see more interest in that topic.  To better understand the points being made, I would recommend bringing up three separate windows on the computer screen using interactive charts from Yahoo Finance. One would be the relevant post and the other two would be the relevant volatility index and its corresponding stock index.  So for a discussion on VIX, you would bring up ^VIX and ^GSPC:


Then follow the charts with the cursor.  Compare what is happening in the VIX with the movement in the stock average, placing the movement in the context of the model.  Then, you will see.

Both LB and RB had a tough night last night. A very loud thunderstorm interrupted our REM sleep, very important for old codgers, and then the neighbor's dog started to bark.  When I first saw that dog as a puppy, I thought that it was a bear cub.  I had to get up close and inspect it right away.  On closer inspection, it appeared to be a  Newfoundland rather than a bear.   Newfoundland (dog) - Wikipedia, the free encyclopedia  The sleep deprivation has even deprived RB of that vision thing that it was so anxious to implement this morning with the funds so generously provided by LB, and it just wants to take a nap rather than pick stocks today.  

Equity preferred stocks are a disfavored asset for me.  Since I started to invest in stocks in either 1968 or 1969, I do not believe that I owned a single one until 2007, when I first started to nibble on some REIT cumulative preferred stocks as trades and then expanded into such securities as floating rate equity preferred and fixed coupon securities like those issued by the large Dutch financial institutions that are in reality bonds but taxed as equity preferred stocks for U.S. taxpayers.  (I am not sure of the exact date, probably during my junior year, that I started to buy stocks and can only say for certain that it was before I graduated from high school in 1969, the decades start to run into each other as I grow older).

This process of buying equity preferred securities did not begin in earnest until the 4th quarter of 2008 when there was the first of two meltdowns in preferred stocks. I was drawn to them solely due to their depressed prices which enhanced their yields.   For me, the most significant problem with them as an asset class is a lack of maturity date.  I am not aware of a single equity preferred stock with a maturity date.  They do have optional call dates for the issuer.  I would never count on an equity preferred being called unless it was clearly advantageous for the issuer to do so.   This may happen when interest rates slide and the issue can be refinanced at lower costs for a fixed rate coupon.  For the floating rate equity preferred stocks, the optional call might be exercised when short rates skyrocket, as they did in the late 1970s or early 1980s, and there is an inverted yield curve, so that it would be advantageous to redeem the floater with the proceeds of a long bond sale.   As a consequence of my disfavor, I will trade them to reduce my risk, lower my cost basis over time and eventually arrive, hopefully, at a point where I am playing with the house's money on them, with the last purchases being the lowest cost ones using FIFO accounting.  My current equity preferred stock holdings are not material and would be valued now at close to 20 grand altogether.  They include the following:  METPRA, GSPRA, CUZPRA, GRTPRF, GRTPRG, FRPRJ, FRPRK, LXPPRD, BDNPRC,  SLDPRC, SLDPRD, CBLPRC, BEEPRA (in deferral), BACPRE, the European hybrids (bonds masquerading as equity:  ING, INZ, ISF, AEB, AEH) and probably some more.

Of these, several are in an enhanced risk stage for deferral due to non-payment of a cash dividend on common stock, and those are the preferred stocks of Aegon, ING, and First Industrial.  As a result, some shifting of those positions to a retirement account has occurred due to U.S. tax consequences of a deferred cumulative dividend.  I do not want to overdue that kind of maneuvering given the U.S. tax rate advantage of an equity preferred dividend.   Of the ones I now own, the most volatile have been the preferred stocks of the Dutch financial giants Aegon and ING.  I now enjoy just watching them move, as if they were on some kind of hallucinogenic drug.

LB finds sustenance in bear markets. Intellectual exercises are its tools of trade.  It provides a laboratory in real time to work on trading rules.  The VIX indicator, and its rules, exceptions to rules, and exceptions to exceptions, is just one indicator developed by LB just before the onset of this bear market.  LB escaped the last one in 2000-2002 out of the time honored trading technique of selling when other people start to lose their marbles or the more polite term would be their common sense.    It is not worth too much time to explain  or justify a movement in stock prices to a 45 P/E.  A highly developed LB just says that is crazy and moves on.  The example that is used to illustrate the point with a story is the trade of the 55 Chevy for the Austin Healy. Left Brain & Right Brain Decision Making/ Ex Interest on 1/12 for some TCs/Chevron warning That kind of decision is just beyond the comprehension of LB, it does not compute, it makes no sense, and about all that it could say about then and now is- "Is that a joke".  And that was when LB was 12. 

On calculating bond yield when the purchase is at a discount to par with a fixed coupon, I have been calculating the current yield and then doing a separate calculation using an annual amortization of the spread between my cost and par value using a straight line method.  I am just trying to get an approximate figure. The way the professional bond traders do it, and I am a novice at bond trading, is explained in this article: Advanced Bond Concepts: Yield and Bond Price  
I will do it my way, even though it may be considered to be incorrect by professionals, since that is how I best understand it.  I understand straight line amortization.   My most significant issue when buying is the current yield based on my cost, and capturing the discount on a long bond at maturity is at best a secondary consideration.  Buying at the discount to par value juices the yield to me over the coupon based on the discounted price, and that is my most important consideration.   So, as the most basic of example, buying at 1/2 of par value doubles the current yield (ADDED: as an example a 10% coupon bond, with a  $25 par value,  bought at a $12.50 total cost= a 20%  yield to that purchaser based on their cost of purchase) . 

Added Comments 7:28 A.M:

It is impossible to focus RB on the task at hand today even after a couple of cups of its favorite brew to kick start the animal spirit and the ingestion of a no doz tablet.  So I wish  to remind everyone that I am bond investor of only a recent vintage.  This shift in focus came from a late realization at the age of 55 that I was no longer a young stud, a revelation that  dawned on me when I  first started to listen to, and like Frank Sinatra music. 

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