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Dow plunges in volatile trading after Fed slashes rates to combat coronavirus
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Stocks fell sharply in volatile trading on Tuesday as an emergency rate cut by the Federal Reserve failed to assuage concerns of slower economic growth due to the coronavirus outbreak. The decision to cut rates by half a percentage point came two weeks before the Fed’s scheduled meeting as the central bank felt it was necessary to act quickly to combat the effect of the virus spreading worldwide. It’s the first such emergency action coming in between scheduled meetings since the financial crisis. The Dow Jones Industrial Average closed 785.91 points lower, or nearly 3%, to 25,917.41; it rose more than 300 points earlier in the day. The 30-stock average gyrated between sharp gains and solid losses after the decision was announced. The S&P 500 fell 2.8% to 3,003.37 while the Nasdaq Composite pulled back 3% to 8,684.09. Investors, in turn, loaded up on U.S. Treasurys, pushing the benchmark 10-year yield below 1% for the first time ever. Gold, meanwhile, jumped 2.9% to settle at $1,644.40 per ounce. “It’s great that the Federal Reserve recognizes that there’s going to be a weakness, but it makes me feel, wow, the weakness must be much more than I thought,” CNBC’s Jim Cramer said on “Squawk on the Street” right after the sudden cut. “I’m now nervous. I’m more nervous than I was before.”
Traders had already priced in a rate cut of 50 basis points by this month’s policy meeting. Fed Chairman Jerome Powell noted the central bank was not prepared to use any additional tools to stimulate the economy aside from rate cuts. This may have disappointed some on Wall Street who were expecting something more from the central bank. Bank shares fell broadly as the benchmark 10-year Treasury yield hit a record low. Bank of America dropped more than 5.5% while JPMorgan Chase and Citigroup slid 3.8% each. The 10-year rate hit a low of 0.906%. “The market is still trying to find its footing,” said Adam Crisafulli, founder of Vital Knowledge, in a note. “The panicked collapse of the last week isn’t something that will be quickly forgotten, and it will take a couple of weeks (at least) before stocks are on firmer ground.” President Donald Trump has pressured Powell and the Fed to cut rates. After the Fed’s announcement, the president tweeted that the central bank “must further ease and, most importantly, come into line with other countries/competitors.” Tuesday’s announcement comes after the G-7 said in a statement earlier on Tuesday they will use policy tools to curb an economic slowdown. However, the statement contained no specific actions. Investors have been fretting over a potential economic slowdown as the coronavirus spreads around the world. More than 89,000 coronavirus cases have been confirmed globally along with more than 3,000 deaths related to the virus. “The worse the economic situation gets, the more likely there will be massive coordinated monetary and fiscal stimulus to offset the weakness,” Tony Dwyer, chief U.S. equity strategist at Canaccord Genuity, said in a note. “There is no way to judge the global economic and EPS impact of the COVID-19 virus as cases globally are still ramping.” Tuesday’s moves follow a roaring comeback rally in the previous session that saw the Dow post its biggest percentage gain since March 2009. The index also recorded its largest-ever point surge on Monday, gaining 1,294 points.. Monday saw U.S. stocks snap a losing streak that had gone on for over a week. Some investors were skeptical that the rally has legs without a significant central bank response. Even if that comes to fruition, investors have their doubts the market has seen the end of its tumultuous trading of the last six days.CNBC’s Michael Bloom contributed to this report.
Backtesting A Simple Trading Strategy For MLP/Midstream CEFs
Investing in heavily discounted CEFs is a common, and usually profitable, investment strategy, as discounts generally boost yields and returns alike. Short-term trading discounted CEFs, buying those with large discounts and selling those with premiums, is somewhat less common, but can be even more profitable if discount differentials narrow, as they usually do. Stanford Chemist sometimes engages in short-term trading of discounted CEFs, so I thought that analyzing the past effectiveness of this strategy for a particular industry might be of interest to readers and investors. In this article, I'll backtest a strategy of exclusively investing in the cheapest First Trust MLP/midstream energy CEF, the best performers in the industry, every month. I've purposely excluded all other industry funds, as these all tend to significantly underperform. Said strategy significantly overperforms the industry average, and the performance of each individual First Trust fund, as heavily discounted funds,, have tended to perform better than average in the past. If investors wish to follow this strategy, they should be looking to invest in FPL, as the fund currently offers the greatest discount in its family and should overperform in the coming months. This fund is, not coincidentally, included in the Tactical Income-100 portfolio. Industry and Fund Selection and Analysis For this little exercise, I've decided to focus on MLP/midstream CEFs, as this is an industry that I know quite well, and one in which I've been relatively successful at selecting appropriate well-performing funds. I've also decided to focus on the four First Trust midstream energy funds, FEN, FIF, FPL, and FEI, as these four funds focus on high-quality low-risk holdings, and have delivered an outstanding performance in the past. Discounts and short-term trading strategies are good, but I see no reason to sacrifice quality and performance to pursue these. These four funds have broadly similar investment strategies, holdings, and investment track-records, although FIF holds significantly more utilities than the rest. As the funds are very similar, I expect the strategy to work, as discount rates are bound to be the main differentiator amongst them. To have some real data backing up the above point, I decided to calculate a correlation matrix for the NAV performance of these funds, plus AMLP as a control. As can be seen above, FEN, FPL, and FEI have correlations of 1.00 between one another, meaning that their NAV performance is basically the same. I think you can make a very strong argument that these funds are functionally identical and that discount rates are the only significant difference between them. As such, investing in the cheapest of these three should lead to outsized shareholder returns. FIF is strongly correlated with these other funds as well, but moderately less, due to the fund's aforementioned utilities holdings. Discounts would be a key differentiator, but not the only one. As such, investing in the cheapest of these four funds should also lead to outsized shareholder returns, but less so. These four funds are only moderately correlated with AMLP, as they focus on higher-quality holdings and tend to perform significantly better during periods of industry stress or bearish sentiment. Performance, and correlations, are higher during bull markets. Taking into consideration the above, I decided to calculate results including and excluding FIF, as the fund seems to behave somewhat differently compared to its peers. Strategy Explanation I'll be backtesting a very simple strategy: buy the most discounted fund at the end of each month, sell the rest. A stronger, more in-depth strategy might consider Z-scores, trade more or less frequently, and consider the magnitude of the discounts before making a final investment decision, but my strategy seemed simple enough to test, and yielded reasonably good results to boot. Let's take a look at the results. Results - Including FIF Results of investing in the cheapest of these four funds every month are as follows: (Source: Seeking Alpha - Chart by author) Investing in the cheapest fund delivered stronger results than investing in any one of the four funds, so the strategy was successful in improving shareholder performance and delivering alpha. Remember that these four funds almost always outperform the index, so the results are quite good compared to the industry average as well. Taking a closer look at just why and how the strategy worked might be of interest to readers, so let's do just that. A bit of context first. FIF is almost always the fund with the largest discount to NAV: Data by YCharts FIF is also almost always the best-performing fund on a price basis, at least partly due to its larger discount to NAV: Data by YCharts As such, we only really have to look at the few cases in which FIF wasn't the fund with the largest discount and see how the fund performed in these few cases to see if the strategy worked. FPL was trading with a larger discount during October 2019: Data by YCharts FPL then moderately overperformed during November 2019 as discounts narrowed: Data by YCharts FPL was also trading with a larger discount during April 2019: Data by YCharts FPL then moderately overperformed during May 2019 as discounts narrowed: Data by YCharts As can be seen above, in the only two cases in which FIF was trading with a comparatively small discount, the fund underperformed relative to the fund with the larger discount. As such, a strategy of investing in the funds with larger discounts overperforms relative to investing in FIF, or in any one of the four funds. Put another way, divesting yourself from FIF when it is more expensive than usual helps shareholders avoid losses once discounts return to normal. Results - Excluding FIF Results of investing in the cheapest of FEN, FPL, and FEI are as follows: (Source: Seeking Alpha - Chart by author) As can be seen above, investing in the cheapest fund delivered stronger results than investing in any one of the three funds, so the strategy was successful in improving shareholder performance and delivering alpha. Excluding FIF actually improved the results of the strategy which, in my opinion, is consistent with the correlation results shown previously. FEN, FPL, and FEI are just so strongly correlated with each other, discounts being their main/only differentiator, that investing in the cheapest of the three is an incredibly strong investment strategy. These three funds generally trade with similar discounts, so it is not possible to analyze every trade or swap to see if it was indeed profitable like I did above. Still, I thought it would be interesting to take a look at one particular swap that was quite profitable. In November 2017, FEN was the cheapest fund out of the three: Data by YCharts FEN then significantly outperformed its peers during December 2017, in large part due to narrowing discounts: Data by YCharts Once again, I can't go through each and every swap or trade in this case, but most of them are similar to the above. In any case, FPL, currently, offers the highest discount out of the four funds, so investors wishing to follow said strategy should invest in FPL. Conclusion Opportunistically buying heavily discounted First Trust MLP/midstream energy funds and selling those with smaller discounts or larger premiums would have delivered strong market-beating shareholder returns during the past three years. Taking into consideration the strong correlation in performance between the funds, I believe that the strategy will also prove successful in the future. FPL currently has the lowest discount rates between the four funds, and I believe that it would make fine additions to any investors' portfolio. Stanford Chemist has currently included this fund in his Tactical Income-100 portfolio, at least partly due to their discounts. Appendix Discounts and returns for the four funds. Returns are for the next month. I've highlighted in green the returns of the most discounted fund. (Source: Seeking Alpha - Chart by author) Discounts and returns for the funds, excluding FIF. Returns are for the next month. I've highlighted in green the returns of the most discounted fund. (Source: Seeking Alpha - Chart by author) Thanks for reading! If you liked this article, please scroll up and click "Follow" next to my name to receive future updates. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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: Note: This article was released to CEF/ETF Income Laboratory members on Jan. 14, 2020.