VIX Smashed As Markets Rebound; Utilities In Focus - Bezek's Daily Briefing

by: Ian Bezek


Markets put in a key reversal Monday. VIX took a historic beating.

My thoughts on utilities' recent outperformance and broader role in a portfolio.

Peabody: A buy after the latest plunge?

I've covered some of my short energy hedge, here's why.

It was looking really ugly there for most of Monday. In yesterday's Briefing, I suggested that the selloff was overdone and that this was a good time to buy stocks.

For most of Monday, that call was looking somewhat silly. After a small initial rally, stocks resumed diving, at one point heading right down to the psychologically important 1,900 level on the S&P 500 (NYSEARCA:SPY). Just after 3 p.m., supposedly due to Fed chatter, but who really knows, markets spiked higher, shooting as much as 30 points straight up.

^SPX Chart

^SPX data by YCharts

For the day, bulls managed to move the headline index up just a tad, a rather meaningless result in total. However, on a level of trader psychology, bulls won a huge victory on Monday.

Up until that rally, it appeared the markets were heading straight lower. Oil (NYSEARCA:USO) got taken to the woodshed yet again, down another 6%. At one point, the front-month contract fell below $31, leaving us surprisingly close to already hitting the $20s. Even most oil bears thought it'd take us a couple months into 2016 to reach that point.

So for the market to close in the green, despite no great improvement in the Chinese situation and a waterfall collapse in oil, was quite the achievement indeed.

Putting up arguably the most important move of the day was volatility (NYSEARCA:VXX) (NYSEARCA:UVXY). I have the majority of my short-term bullish exposure to the market via the short VXX/UVXY trade, so Monday marked a significant and much-awaited reversal in my fortunes.

UVXY Price Chart

UVXY Price data by YCharts

I'm sure it's happened occasionally, but I can only remember one time in the past three years that UVXY has dropped more than 20% that quickly, and I've been watching almost every tick of UVXY trading for years. The move between 3:15 p.m. and 3:45 p.m. was simply breathtaking.

Unlike the previous late day rallies that managed to only slightly shore up an otherwise fetid market and did nothing to the VIX, this rally simply wiped out volatility. Kaput.

UVXY Price Chart

UVXY Price data by YCharts

Despite the craziness of last week, volatility never really spiked like it did yesterday. And the subsequent collapse in volatility is simply unlikely any other retracement of recent days. This change of sentiment was different - way different - and bears need to be on guard. At least in volatility, the chart shows all the telltale signs of capitulation.

The market could still go lower here, but if people can shrug off another firing squad type day for oil and send stocks higher, you have to think a big rally is near.

One final note on my personal trading book, I covered a good chunk of my short natural gas producers (NYSEARCA:FCG) trade. Here's a chart since we initiated this position in October.

FCG Chart

FCG data by YCharts

I ultimately think this gets down into the 2s before bottoming out, but I'm quite bullish on the broader market, and oil is overdue for a short squeeze at some point. Earnings for the more purely nat gas producers might be slightly less bad going forward as well, since natural gas (NYSEARCA:UNG) has rebounded smartly in recent weeks.

This hedge has done heavy lifting, protecting my portfolio as many of my long positions have gotten clobbered. Having accomplished its job, I've covered many of my shares. I will be happy to revisit this on any bounce - the low 5s would be an attractive level to start adding back more size short on this.

Utilities: Notable Outperformance

There are only a handful of sectors that are flat or up so far this year. Utilities (NYSEARCA:XLU) are one of those, with the headline XLU sector ETF turning in a +0.1% performance so far YTD vs. -6% for the S&P 500.

The performance of utilities is slightly surprising. They are a traditional safe harbor sector, so admittedly it's not shocking to see them bid from that. And as we've discussed, other safe-haven stocks such as Wal-Mart (NYSE:WMT) that were 2015's cast-offs are suddenly hot commodities again this year.

Still, one of the given reasons for the 2016 selloff has been concerns related to Fed hikes. Due to the capital intensity of their industry, utilities are among the companies most impacted should rates actually shoot higher.

So if you were seeing the market selling off due to interest rate concerns, then you shouldn't see XLU green. My take on utilities in general is that they are overrated as a market timing indicator.

Many seemingly smart folks trot utilities (and also transports) out on occasion to prove some point about what the broader market will do. When I actually track these predictions, the predictive value of both sectors generally ends up being quite low.

At the risk of not looking like a super-smart market predicting guru, I'm simply going to say that utilities are doing well as they were among the harder hit stocks in 2015. On a relative basis, they are a good source of defensive value for people suddenly fleeing riskier harbors.

Utilities seem reasonably priced for yield-focused investors wanting to nibble. I don't see their pricing being particularly compelling, but it's not bad either as a sector.

For me personally, I'm not buying utilities here. I don't need high yield at this stage of life. I'm willing to accept it if it also comes with reasonable growth prospects or a bargain purchase price, but being young, I have no desire to almost completely sacrifice growth for an extra point or two of yield.

I'd refer investors back to my article on the performance of the 30 main S&P industries over the past 80 years. Utilities came in 15th out of the 30 sectors, dead center of the pack for long-term returns. Like 17th ranked telecoms, these sectors provide completely average returns, with yield driving the return component. If you're in a stage of life where that's what you want to focus on, utilities aren't a bad choice.

I try to stay overweight the top 10 sectors, in particular food, liquor, energy and health care, which all rank among the six top performing sectors of the past eight decades. One of the best ways to beat the index is to invest in sectors that have stronger and more durable profit generation engines than the average company. Utilities with their regulated profitability, high capital needs and limited growth prospects simply don't offer the same sort of upside generally.

Quick Takes: Coal, Preferred Shares

Peabody Energy (BTU) shares got whacked for a more than 20% loss following competitor Arch Coal (ACI) declaring bankruptcy. There are clear reasons to expect Peabody may follow the path Arch went down.

Peabody is engaging in the same sort of debt restructuring talks that provided excitement and a short squeeze but ultimately didn't save Arch last year. Arch's bankruptcy filing likely means that the companies' mines will continue to run full bore for the time being rather than cutting back supply.

Even the recent reversal in natural gas has done little to bring cheer to Peabody's shares. SA author Vladimir Zernov raises the interesting idea of a "critical mass" of bankruptcies. Once enough competitors file, the survivors almost have to as well to compete with the leaner cost structures of the recapitalized entities.

Still with Peabody shares back into the $5s post-reverse split, the stock may have plenty of upside if anything breaks right for the company.

BTU Chart

BTU data by YCharts

I can't get comfortable with the trade; the debtload looks insurmountable from my perspective. But plenty of smart people I respect really like this trade, long stock or Peabody bonds, and after Monday, the price of taking a punt on it went down a good deal.

Further reading: William Koldus': Peabody Is My Top Idea For 2016 (requires PRO access) and Courage & Conviction Investing's: Peabody Energy, Positive Leading Indicators Are Emerging.

Finally, if you are long the iShares US Preferred Stocks (NYSEARCA:PFF) ETF, think again. SA contributor Arbitrage Trader posted a masterful critique of the ETF Monday.

Showing deep knowledge of the ETF's inner workings, Arbitrage Trader shows how about 30% of PFF's capital is effectively not being invested in a seemingly economically efficient manner. A large portion of the ETF's money is in callable preferred shares trading above par, which by definition have virtually zero potential upside.

If all those shares were called, the ETF would suffer moderate losses. Furthermore, the ETF appears to be much less passive than you might expect, with active management decisions seemingly leading to a potential drag on returns.

Arbitrage Trader concludes that most investors looking to the preferred space could do better by looking at PFF's holdings and then excluding obvious poor selections that are trading above par and are likely to be called, freeing up deadweight capital to be invested more beneficially.

If you are long PFF, I'd read the article and consider its implications carefully. As for me, PFF is off my list of things to buy should it get cheaper following a potential interest rate increase.

Disclosure: I am/we are short FCG, VXX, UVXY.

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.

Additional disclosure: Long WMT.

Editor's Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.