Thursday, October 6, 2011

More Discussion on Asset Allocation in Unstable Vix Patterns/Sold 50+ ONFC at $9.35/Added 50 BTZ at 11.24

According to the WSJ, the government is going to allow borrowers, who were in some stage of foreclosure in 2009 or 2010, to claim compensation for bank mistakes. This could impact as many as 4.5 million homeowners.

A couple of economic reports yesterday suggested that the market is too negative about the U.S. While not great, the ISM services index was 53% for September, staying above the 50 threshold showing expansion. The new orders component actually increased to 56.5 from 52.8. The other report was from ADP showing an increase of 91,000 private sector jobs from August to September.  While that is unsatisfactory, that snapshot of the labor market appears to me to be inconsistent with the doom an gloom pervading the markets now.

I will add something with cash flow after viewing news inconsistent with Mr. Market's forecast about the future. I will discuss that small add in tomorrow's post, a 30 share buy of Pepsico at $59.95. 

I am on automatic pilot in making certain investments, notwithstanding my negative view of the market. One way to dig out of a bear market is use cash flow to purchase more securities, particularly on down days. I was able to recover quicker from the meltdown after Lehman's failure by following that simple dictate.

I have also flagged certain securities for repurchase after being sold recently. As an example, I previously mentioned that I would buy back 50 shares of Microsoft below $25 after selling 150 shares at higher prices. SOLD 100 MSFT @ 27.9 (July 27, 2011 Post); Sold 50 MSFT at 26.7 (9/6/11 Post). I am reinvesting the dividend to buy additional shares.

The only requirement for this repurchase is that the price has to be below $25. The timing of the purchase after that condition is met is flexible.

Instead of buying MSFT when it fell to below $25 earlier this week, I waited to see whether PEP would decline below my $60 buy target. In an Unstable VIX Pattern, I will continue buying common stocks but in very small lots and will focus on financially sound companies. (see e.g. posts from March 2009 including the following: Buy of KO at 38.72 Buy of HNZ at 31.67 Buys of CPB at $25.8 and SYY at $19.46 Buy of UL at $18.22 BOUGHT Kraft at $22.26 & Nestle at $31.28 Bought PG at $47.59; currently own SYY, KO, UL)

The market is being driven by fear feeding on itself, which will likely present long term buying opportunities. Many stocks seem to me to be attractively priced now, but could easily trade lower in the current environment. It almost becomes a matter of feel when to take a position. Since I view the risk to be to the downside, I will chop purchases into multiple small odd lots and will space them out in time. It would not be surprising to see a waterfall decline when and if the solvent European nations decide to let Greece fend for itself, one realistic scenario for the future.

1. Sold 50+ of ONFC at $9.35 on Tuesday (Regional Bank Stocks' basket strategy)(see Disclaimer): The shares of this small bank, headquartered in NY, were bought at $7.7 and I reinvested one dividend to buy additional shares.

The updated total for realized gains for this strategy is $7,959.01. Item # 3 Realized Gains Regional Banks The unrealized loss in the remaining positions is growing. Some of the banks are trading at levels now below their low point in March 2009, and I will likely average down on a few of those.

2. Added 50 BTZ at $11.24 on Tuesday (see Disclaimer): This bond CEF has not done well since my initial purchase. BTZ invests mostly in investment grade bonds, congregated in the BBB category. The fund recently announced a small raise in its monthly dividend.  The new monthly rate per share will be $.0765. BlackRock The old rate was $.069. BTZ Distribution History Assuming a continuation of the new rate, which would not be prudent, the yield at a total cost of $11.24 would be around 8.17%. I am currently taking the dividends in cash. The total BTZ position is now close to 600 shares with 200 held in the ROTH IRA.

One reason for the decline is that the discount to net asset value has been expanding recently. On 10/3/11, BTZ reported a net asset value per share of $13.37. Based on a closing price that day of $11.39, the discount to net asset value was -14.81 at that time which is high for a fund with a lot of investment grade bonds. The decline in price last Tuesday was almost sufficient to pay for my $7.99 brokerage commission on a 50 share purchase, and that was another factor for making the add.

Another reason for the decline is that this fund does invest in junk bonds which have been clobbered over the past several weeks. As of 6/30/11, the fund reports a 28.3% weighting in high yield bonds and a 49.6% in investment grade. The remaining allocation is primarily in what the fund calls "preferred stocks" which are mostly "trust preferred". BTZ Portfolio Those securities are in reality junior bonds. Regular Preferred and Trust Preferred The ones issued by financial firms have been hit hard in recent days.

BTZ does use leverage. This will work when the assets bought with borrowed money appreciate in value and generate a good spread over the cost of funds.  When short and long term rates rise in tandem, then this kind of fund will suffer with that double whammy, likely to turn into a triple whammy as the discount to net asset value expands as investors flee in the face of buying interest drying up.

This is a link to the SEC filed shareholder report.  The BTZ holdings list starts at page 34. The "preferred" securities are listed starting at page 36. Unfortunately, at least for now, those issues are mostly from financial institutions including banks and insurance companies.

Before the market started to rally on Tuesday late in the day, I noticed that the bond ETFs TLT and LQD had turned negative. The 20+ year treasury bond ETF had been up, trading as high as $125.03 early in the morning, before closing down $1.54 at $122.27. It was as if the large investors lightened up on their fear trade by selling TLT and then took stocks up later in the day.  

On Tuesday, the day of my purchase, BTZ closed at $11.26, with a NAV per share of $13.16, creating a discount to net asset value as of that time of -14.44.

BTZ closed at $11.34 yesterday. The next ex dividend date for the monthly dividend is 10/12/11.  The net asset value as of yesterday's close was $13.1 per share, creating a discount at that time of -13.51.

Junk bonds continued to be slammed by the market, and this fund has a significant weighting in that category (see underlining above)

3. Allocations in Stable and Unstable Vix Patterns: I have repeatedly discussed this topic since starting the blog back in October 2008. I view it as the most important category in this blog.  Two of the earlier posts are the following:

More on VIX AND ASSET ALLOCATION (November 2008)
When VIX Model Gives A Signal To Change Asset Allocation-Each Individual Needs to Assess Their Own Situational Risks (March 2009)

The model is flexible in that the individual must tailor their reaction to the Model's signals to their own unique circumstances.

Once the model identifies an Unstable VIX Pattern, the reaction to it should vary among individuals. Those circumstances include unique situational risks, usually involving a need to spend money invested in stocks, the tolerance for for volatility and risk, and the ability to form a constantly shifting allocation plan based on a knowledgeable assessment of big picture issues. Financial planners will not want to perform the dynamic asset allocation necessary to navigate a Unstable VIX Pattern. Vix Asset Allocation Model Explained Simply  It is just too difficult for them, so the parrot phrase buy and hold has proven useful as an alternative to thoughtful advice.  

For the lazy and time challenged, a Mr. Nervous, one response would be to sell all stocks and buy some kind of alternative investment after the Trigger Event. That investment could be treasury bills, FDIC insured bank CDs, and money market funds for those interested in preservation of capital. Depending on the circumstances then prevailing, another alternative might be a bond ETF (e.g. TLT, IEF, or BND). I am not referring to a purchase of this kind of investment now.

For example, the model flashed a Trigger Event in August 2007 that would require a reduction in the stock allocation. The historical experience, which may not be repeated, is that the investor will be able to sell stocks when the VIX returns to below 20 after that Trigger Event, allowing for a better exit point than prevailing during the Trigger Event. VIX Chart from 2007: Alerts and Triggers Major Disruption of Cyclical Stable Bull VIX Pattern This occurred in October 2007.  The Unstable VIX Pattern has continued since that Trigger Event, and our Mr. Nervous is waiting for the Green Light signal before buying a single stock. And then this person would buy a total stock market ETF only.  This hypothetical investor bought IEF in October 2007 and Sold IYY at the same time.

Historical Prices IYY and IEF for October 2007:

IEF Historical Prices | iShares 7-10 Year Treasury
IYY Historical Prices | iShares Dow Jones U.S. Total  Stock

I will use the adjusted close numbers and assume a purchase on October 15, 2007. The adjusted number is reduced from the closing price on 10/15/2007 to reflect subsequent dividends and would consequently be a benchmark for total return. If I am doing that incorrectly, one could just take the unadjusted numbers and call the income generation a wash which would be close given the low yields of both securities:

Period: Unstable VIX Pattern 
Bond IEF Adjusted Close 10/15/2007: $72.58    Close 10/4/2011 $105.83 Net Gain 45.8%

Stock IYY Adjusted Close 10/15/2007: $70.64    Close  10/4/2011 $56.23 Net Loss 20.39%

Mr. Nervous is a genius, and arrived at that point due to a strong desire to avoid heartburn and motion sickness, no up and down nonsense for Mr. Nervous.  While he has missed a lot of fun since October 2007, I would not quarrel with the results compared to that buy and hold stock investor following the advice of their financial planner.

The same type of analysis could be performed after the May 1991 Green Light Signal, lasting until October 1997, where the investor would have moved from bonds to stocks; the Unstable Vix Pattern from October 1997 until March 2004 (actually a few days before 3/1/04, ^VIX Historical Price), when this investor would have stayed in bonds; and the Green Light Period from March 2004 to August 2007, back to stocks from bonds until the August 2007 Trigger Event.  I will just run the analysis for Mr. Nervous for the last Green Light period. In this comparison, I will use the unadjusted numbers to see what happens.

Period: Stable VIX Pattern
Stock: March 1, 2004  IYY  3/1/04  $55.08 IYY Historical Prices  Close 10/15/2007 $75.6 IYY Historical Prices Net Gain Before Dividends: +37.25%
Bond IEF March 1, 2004  $86.52  (IEF Historical Prices)   Close 10/15/2007 $83.13 IEF Historical Prices  

The dividend yield for the bond ETF IEF would take its total return into the green slightly for this period. The dividends paid by IYY would also increase its total return, possibly over 50% on a cumulative basis. I did not try to run those numbers but just eyeballed them. I am really not set up to compare total return numbers, including dividends, for these kind of securities.

Another investor is bolder. I will call him Mr. Stock Jock (SJ). The SJ realizes there is money to be made during the Unstable VIX Pattern period. The largest rallies can occur during such periods and why miss all of that fun.  We all know the identity of the Stock Jock. The SJ is willing and able to withstand risk and has either no or minimal situational risk. For the Stock Jock, the Trigger Event is just a signal to send the LB into hyperdrive.

The entire trading strategy changes in an instant. No longer will this investor hold most stocks for the long term. Sell the rips becomes the new mantra. Still, even this Stock Jock wants to raise cash for later use and reduces the stock allocation significantly after the Trigger Event. SJ may be a wild and crazy guy but he is not an idiot.  Cash is the fuel for what is about to happen, a means to play the volatility.  Funds will flow into and out of stocks based on several indicators, sometimes with major shifts into or out of stocks.

One indicator is the movement of the Vix as interpreted by the Model. When the VIX falls below 20 during the Unstable Vix Pattern period, stocks are sold. Stocks are bought in small increments when the VIX moves to and exceeds 30. This is the whipsaw pattern characteristic of the Unstable VIX, Phase 1.

In addition, the more adventuresome investor would be timing hedges based on the movement of the VIX. Hedges are bought during those brief periods when the VIX falls below 20 and then pared or sold on spikes to 30. The movement below 20 would be occurring during a stock market rally, so stocks are sold and hedges are bought.  This pattern will repeat itself over and over during the Unstable VIX Pattern, Phase 1. This can be a mechanical strategy or an active one as to security selection.

Another simple indicator is to wait for the catastrophic phase of a long term bear market. One will happen. By catastrophic, I am referring to a greater than 50% decline in the market over a short period of time.  This kind of decline occurred in the long term bear market starting in 1966 during 1974. The catastrophic phase in the current long term bear market started to develop in September 2008 and hit its apex in early March 2009. Generally, the trigger is to wait for a greater than 50% decline and then increase stock buying.

Possibly the SJ will have to make a judgment on whether a garden variety cyclical bear market is in the offing or the catastrophic one. This can be made with reference to the elevation in the VIX and confirmed by an assessment of external events. For example, look at the VIX chart after Lehman's failure. ^VIX Historical Price This was obviously a catastrophic event formation. The clear marker was the move on 9/29/08 with the spurt to 46.72 from a prior close of 34.78 on the prior Friday, 9/26/2008. On 9/26/08, the S & P closed at 1,213.37.^GSPC Historical Prices The closing high was at 1565.15 on 10/9/2007. Take 50% of that last number, or 782.575, and a close below that number would trigger the buying under this rule. That day occurred on 2/19/09:  ^GSPC Historical Prices

Another indicator is to identify the general area of long term support in the structural bear market.  I believe that support is mostly at S & P 950.  The characteristic of a long term bear market is frequent up and down moves, but the market continues to return to a level close to where it started that long cycle.  The long term bull cycle is more like a gradually slopping, 45 decree angle, with a few short term blips along the way. The Roller Coaster Ride of the Long Term Secular Bear Market  For this assessment, it is important to identify the long term cycle and the reasons for it.

During Phase 2 of the Unstable VIX Pattern, the current one, the Stock Jock reverts to extreme caution. The world has become a more dangerous place for investors. Dangers always lurks, but now it is on amphetamines and steroids.  With that danger comes opportunity. No matter how fearful, cash flow will be used to buy securities during those periods, preferably in income generating stocks and bonds, assuming a significant decline in price.  The Trust Certificate exchange traded bonds were crushed over the Lehman failure and provided excellent buying opportunities for several months after September 2008. Trust Certificates: New Gateway Post Buy orders will be sliced into smaller increments and spaced out over time.

Even the SJ will revert to a buy and hold strategy, with several broad based stock ETFs, when and if the VIX forms a Stable VIX Pattern. HK has decreed that no more than 3 stocks can be sold per month during that pattern. There is no limit on the number of purchases.

Please note that there was constant buying from September 2008 to March 2009 that accelerated in March-May 2009, close to 100 grand flowing into stocks during that period. This trading system requires buying with cash flow and a reduction in the cash allocation when valuations become compelling.  Would you buy now Pepsico at less than $50: Pepsico Buy/ DJIA volatility index below 30 (5/6/09 Post, later sold).

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