Introduction: This article presents evidence that "risk on" assets may have topped. If so, rather than shorting them, speculators and longer-term investors may benefit from looking to acquire the premiere "risk off" asset, the long-term Treasury bond.
One of my investment buddies, a senior executive with one of the major investment banks before retiring a while ago, always reminds me that Mr. Market will fool the greatest number of people. Under that reasoning, I always remember that there are two sides of every trade. The bears have their reasons for selling at a given price, and often they know more than the bulls. That may be especially true at extremes in the futures markets, where the commercial hedgers have greater knowledge than the speculators.
Background: Sometimes within a set of market cycles, one looks back and perceives an opportunity to act upon a recurring set-up when it comes around the second time. This time may be now, as 2011 may be repeating in front of our eyes. Interest rates may be set to surprise the greatest number of people and collapse as they did as the post-2009 boom decelerated in most of the G-7, and several eurozone nations tipped into recession or depression that summer. If so, ETFs that provide exposure to the one asset that reliably has been moving in the opposite price direction to "risk on" assets may be getting timely as a trade, not only as a hedge. The most liquid one for traders is the iShare Barclays 20+ Year Treasury Bond Fund (TLT). If one buys it, one receives monthly payments providing more interest income in one month than a money market fund pays in several years. Here is the reasoning, focusing on the futures markets. But that's not the point of this article. TLT is an ultimate contrarian play for capital gains to come in the months ahead. Note, of course several other ways exist to go long Treasuries.
I believe that to generalize, TLT and related T-bond vehicles are superior to shorting an index. Short-sellers owe margin interest and are responsible for dividend payments. TLT returns 3% yearly. Shorting the S&P or other market is arguing with US history, which suggests that over time, the stock markets provide a positive return of about double the 10-year T-note yield, which is currently 2%. This simple metric suggests a 10-year average annual total return for the S&P of about 4%, with of course a wide range. In any case, if the stock market is priced to return 4% yearly, and one is out margin costs, one has to get one's timing very right to make money shorting a stock index. However, if one is unleveraged, one could hold TLT forever if one wants if one is wrong on this bet. Over many years, TLT will act like a floating rate fund as it sells shorter-duration bonds and purchases higher-yielding, longer-duration ones yielding higher rates. I am not long TLT for that reason, but if need be, I plan to hold it indefinitely.
In any case, the trading reason to consider buying TLT either now or at the "right" time is that it, and T-bond rates, have been moving inversely to risk on assets. These are looking primed for a fall, not today or tomorrow, but in a reasonable time frame. Here's the arguments from futures positioning, followed by a discussion of one method of valuing stocks that also suggests that fundamentally, they are ahead of themselves, even in a non-recessionary, non-bear market situation.
The "case": Let's start with "Doctor Copper". He (she?) may be giving a negative prognosis. Here's some recent history. In June, 2011, I wrote "Important Battle at Four Dollar Copper":
Long called "Dr. Copper" for its alleged ability to "diagnose" (reflect) the strength of the US/global economy, this metal is not politicized as is oil. (NATO is not assisting in getting rid of Mr. Qadaffi because he controls 2% of the world's copper market.) Thus it more fairly than oil represents supply and demand in diverse parts of the world's economy.
As you see, copper found intense upside resistance for several years at $4/lb. It then broke through to all-time highs in the inflationary sequelae to the 2008-9 bust. If $4 can hold, I think that would be big for the commodities bulls. If it falls back well into the prior trading range, that will embolden the deflationists.
It's worth watching this one.
The futures chart of copper from Finviz.com was as follows:
Next, the current Finviz chart, which begins almost two years after that one:
I interpret these as follows (please note my focus in over thirty years of investing has been equities, not futures, so I claim zero expertise in futures markets). Per Finviz, the green line represents commercial hedgers. The red line represents large traders, typically larger hedge funds and commodity pools (speculators, aka "specs"). The blue line represents small traders. The red and blue lines are offset by the green line. In other words, the commercials take the opposite side of the trade as the large and small traders combined. Thus when the "specs" are bearish, the green line will be above the zero line, representing net long positions by the commercial hedgers. Vice versa for the periods where the green line is below the zero line.
What we see is that the important battle at $4 copper I described has been won, so far, by the bears (deflationists). Please consider the alternating periods of spec bullishness (green line below zero) and spec bearishness.
To date, each cycle of spec bullishness has been as intense (commercials negative 20,000 contracts or so) as the one before, but each one occurred at lower highs in copper's price. Note: clicking on "Daily" on the menu brings you a one-year view. There is a clear pattern of bullish spec positioning peaking at lower highs. Might this say something about the global economy, and warehouse stores of copper (think China)? Here is the roughly one-year chart on copper:
Copper's price may have started subtly breaking down since the 2011 high, and is now challenging the uptrend line of higher lows. Lower highs, higher lows - which will prevail? Well, the specs remain quite bullishly-positioned despite the recent sharp price falls. If they start to sell, I would expect support to come in laterally at last summer's low. Look what was happening to interest rates then. The 10-year US govvie traded toward 1.4%, compared to 2% now. The yield of the 30-year long US govvie was much lower than today. TLT, now trading just under $117, was above $130 briefly.
The same pattern with copper appears in crude oil. Here is the multi-year crude oil chart from Finviz.
Even if the post-Fukushima related spike in crude shown in early 2011 is excluded (and I'm not sure it's fair to exclude it, as commodities were going wild around then unrelated to that disaster), what the chart shows is repeated surges of heavy spec buying. It did not take much spec buying for the price to rebound off the oversold 2008-9 lows, but look what came next. Repeated surges of heavy spec buying have produced a 2-year picture of lower price highs. If crude oil were a stock, and repeated rounds of heavy buying produced lower highs, most of us would avoid it unless we felt we had a bullish fundamental position that the market was ignoring.
Currently, the Fed announced the first half of QE 3 late last summer (MBS purchases), and its second half (direct T-bond purchases) in December, if I recall the dates correctly. The specs went very long crude oil, expecting this to be quite inflationary. But once again, the price peaked and has started to turn down. Worse, the price has started to turn down with the spec longs at or near multi-year highs in the number of long contracts they hold.
What happens if these specs liquidate en masse their leveraged, long crude oil positions? As with copper, every downtrend in the price of oil has led to a bull market in the price of TLT (i.e., Treasury yields have fallen). Why should it be different this time?
The potential for deflationary price actions in Dr. Copper and crude oil is further suggested by the downturns in precious metals prices. The sudden collapse in the price of gold is well known. This may suggest diminution of liquidity in the global financial system. The last serious downturns in gold's price occurred in the late summer/fall of 2011, when much of Europe was tilting into recession and the Fed did not begin QE 3 as was widely anticipated. Before that, the last serious move down in gold occurred in 2008, when the Lehman fallout sucked liquidity out of all markets except the Treasury market.
Let's go to some other charts of the key markets. First, three stock market charts, that of futures on the Russell 2000, the DJIA and the S&P 500:
Both these more lightly-traded contracts show record level of spec bullishness as far back as the charts go. For the DJIA, I add the net positioning of the standard-size contract and the mini (above and below each other) to make that calculation.
The leading ETFs for those indices are the SPDR Dow Jones Industrial Average (DIA) and the iShares Russell 2000 Index (IWM). The positioning is more moderate for the NASDAQ and the S&P 500 index, which I want to focus on rather than the Dow 30. This is because the "500" is the core index, and correlates closely with the Dow.
Market averages may be ahead of themselves: If you click through to the S&P 500 futures chart, you will find that as of now, it also shows spec bullishness, but at a level that has been seen with both bull and bear moves. The leading ETF representing the "500" is the SPDR S&P 500 (SPY). I am cautious on it for two reasons. One is that the message I see from the charts of copper, oil, and gold is to be cautious on all risk assets. The other is that Value Line, the best-established independent stock advisory, has a good track record in forecasting the average Dow price for a calendar year. It was spot on with its year-end 2011 published forecast for the average DJIA for 2012. It has been very close from 2009 onwards, actually. Value Line has predicted 13,440 for the average Dow for 2013. Value Line uses three variables: log functions of the rate of change of dividends, AAA corporate bond yields, and earnings for, in this case, 2013 versus 2012. Those three variables are in descending order of importance: surprisingly, the same percent rise in bond yields is more important in their formula than a rise in earnings. (A rise in bond yields is negative for stock prices.) Since interest rates are higher now than at year-end, and Value Line's expectation was for rates to be unchanged, perhaps if they estimated now, they would get to (a total guess) 13,200 for the average DJIA for this year.
There is more, though, and it is important. We have to consider that between economic growth, retained earnings and inflation, the Dow tends to rise from one year to the next. Thus the Dow in February should tend to be below the average for the year as a whole. Volatility aside, on average, the average price should come at midyear and the highest price should come in December. Thus I favor some reversion to the mean in stock prices, and "expect" 13,000 on the Dow to be "fair value" as of today. This could easily allow a correction to 12,500, even in the absence of recession or any serious fundamental shock to the economy or financial system.
The case for lower interest rates: Thus I believe that downward price adjustments to risk assets is a reasonable possibility in the months ahead. How to either hedge against that or take an optimal position to generate capital gains, if one wishes to take this more aggressive, contrarian stance, is the next and final topic. Here is the futures charts on the 30-year T-bond, first the multi-year one and then the one-year one:
The shorter-duration chart shows that when the Fed announced QE 3 was coming, specs went long the long bond to a major extent (green line very negative), then suddenly flipped and have gone risk on (short the bond). Going heavily short the bond is consistent with their bullishness on copper, oil, (not shown above) the industrial metals platinum and palladium, and lumber; and going short the Japanese yen. Even though some use the large traders category as a proxy for hedge funds, they have not been hedging. At least as judged by the futures markets, they are, collectively, "all in" on the risk on trade. However, the 2-year T-note remains at a pitiful 25 basis points. The 2-30 spread of 292 basis points is historically high. "Everyone" expects it not to narrow by the yield of the long bond dropping.
The above is one sentiment-based reason to consider being long the long bond. But sentiment is not good enough to go long an asset. Here are other reasons to consider a long TLT position, in addition to the above points.
A) The Fed never, ever has to sell its bonds. Not only does the Fed never have to sell, it is hoovering up a massive percentage of long-duration Treasuries. The long-term Treasury is a relatively small market. This proved beneficial to traders during past crisis. In 2008, the 10-year yield bottomed at 2.08%. A relative shortage of the long bond meant that the frantic search for good collateral brought its yield to 2.48%.
This also happened in Japan in 2003. The 10-year yield collapsed to .50%. Their 30-year govvie bottomed at or below 1.0%. In a crisis, even if transient, the duration will not matter.
B) You never know if or when a crisis will appear. What events could bring big profits to a speculator/investor in the long Treasury? Beyond the obvious answers out of Europe or an economic crisis in China, the possibility of a recession in the US comes to mind (gasoline prices are up 14% in the past month).
C) Deflation could happen here, and it could be the "good" form of deflation. Less obviously, "good" deflationary pressures may bring deflation to the US as has occurred in Japan. Robotics, further improvements in information technology, improved fuel efficiency for automobiles, more global use of hydrocarbon recovery from shale, diminishing population growth all come to mind. Thus, as in Japan, central bank action may be insufficient to offset these good deflationary pressures along with continued deleveraging in the high debt:GDP such as the US. Of course, "bad" deflation could appear, which Japan has also endured.
D) Negative interest rates could come to America. In another crisis involving "bad" deflation as in 2008-9, the Fed could reasonably institute negative short-term interest rates. After all, people pay to store everything outside their own property. We pay to temporarily warehouse furniture before relocating; we expect to pay to securely store gold, art, or a car if leaving the country for a year, and so on. It costs money for a bank to both store your deposit, which is a loan to the bank, and keep the funds available to return your money either to you or to a payee on short notice. If the Japanese scenario of no net inflation, and perhaps some mild deflation, arrives in America, and short-term Fed policy rates drop to zero or below zero, savers may have to be presented with the bill to store their money but be ready to return it on demand.
In the above situation, there could be unprecedented demand for any secure positive yield.
There is precedent for negative interest rates, out of Switzerland and Germany within the past year.
E) The US government will always get its funding. I reject calls for hyperinflation in the United States. What I think is far more likely is that if Keynesian economics "requires" an increase in the Federal deficit, the cost of funding will come down.
Summary: "Everybody knows" that at today's interest rates, the long T-bond is a ridiculously poor trade and a miserable long-term investment. However, the actual price/volume action in such inflation hedges as copper, crude oil and gold raises questions as to whether this meme has led the speculator community to go all in on, and stay in, the "risk on" trade at the wrong time. If the risk on trade reverses, the price of the long Treasury bond will likely rise as traders compete for the fairly small supply of the long bond that is not closely-held by the Fed and other long-term holders such as insurance companies and other central banks.
No one can know the future. The diversified portfolios I manage are certainly not majority in on the deflation/risk off trade. Increasingly, though, I see value in TLT and similar choices both as portfolio diversifiers per Modern Portfolio Theory and also as more aggressive, speculative capital gains vehicles for the months ahead.
Please note that I am expressing my personal thoughts only. I am not an investment adviser. I have never traded in the futures markets. Nothing herein comes close to representing investment advice.