Triple bottom in MORL

It looks like a triple bottom has formed, or is about to form, in MORL.  The middle bottom around July 27th was the lowest.  This is the inverse of a classic “head and shoulders” pattern that marks a top.  The inverse supposedly marks a bottom.  It is called a head and shoulders bottom reversal.  Another article explains both top and bottom head and shoulders patterns and how to trade them, cautioning to wait for the pattern to complete (I am always jumping the gun, it seems).

If tomorrow continues the uptrend evident in the second half of today’s trading, this will be confirmed.  Yield over the past year, at today’s closing price, was 26%, up from the typical 20-21%.  Forward yield is probably still in the typical range, as some of the underlying components have cut dividends.

If you need more dividends, or would like the benefit of diversification, or to reduce your total capital exposure to losses in dividend companies, then this might be a time to add to your holdings.  I wouldn’t double them or anything dramatic like that.  There might be further damage to these financial companies when interest rates rise in September.  But at least some of that effect is already anticipated.

I find myself having been overly optimistic about the speed of recovery in oil prices like much of the rest of the world.  Rather than sell at stupidly low prices, I’ll use a little more MORL to pay down the margin a little faster.  The amount used to pay margin interest, which will increase when interest rates go up, is fully canceled for tax purposes by the margin interest deduction, and I might need some more dividends to cover future higher margin rates.  But eventually I’ll own outright all that stock I bought and it won’t have cost me a thing, since it was bought with other people’s money, so I don’t really get overly concerned about a paper loss.  For a trader, of course, the loss is real, but not for a long term holder who didn’t use his own capital.

I want to update a previous analysis I posted on MORL, as to why it is not much more volatile than its components.  Most leveraged ETFs are designed to multiply the volatility, and they do, but with compounded losses.  MORL is an ETN, so no compounded losses from volatility.  But more importantly, it is designed to multiply the dividends, not the volatility.

Now, assume the value of MORL is mostly based on dividends, and it will remain at around a 20% yield.  Now suppose the underlying dividend of the component companies is $100, and increases by 10% to $110.

MORL has doubled the $100 dividend to $200.  It will also double the $110 to $220.  How much has MORL’s dividend increased?

Well, it increased by $20, from $200 to $220.  $20 / $200 = 10%.  Hmm, that is exactly the same amount by which the underlying components increased.  The volatility of the dividend is not leveraged.  And since the volatility of MORL is mostly based on its dividend, then its volatility is mostly not leveraged by the 2x ratio.

This will not hold, of course, if several major components of MORL go bankrupt.  But to me it means that in an ordinary business cycle, as opposed to a “financial crisis,” MORL should be no more volatile than its components.  And it hasn’t been.  The oil decline, which is driving most of the drag on the U.S. economy, is an ordinary business cycle.  A classic inventory excess problem.

Cautionary note:  My friend the financial consultant who works for the same bank that runs MORL thinks it is very dangerous.  But  he works for a branch in a different country than the one that runs MORL, and hasn’t been able to provide any specific information into its structure, it is just his gut reaction to “leverage.”  I would counter than holding just one or two of the components is even more dangerous.  I was caught holding Novastar financial and Luminent mortgage when they went bankrupt, a lesson I remember well.  But some financial companies fully recovered and then some, which should keep MORL at least functional.

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