Just One ETF: Shorting Treasurys as a Change Management Model Flashes Bearish Bond Signals

| About: ProShares Short (TBF)
Several times a week, Seeking Alpha's Jason Aycock asks money managers about their single highest-conviction position - what they would own (or short) if they could choose just one stock.

Nigam Arora is the founder of two Inc. 500 fastest-growing companies and developed the Theory ZYX of Successful Change Management, which he applies to investing to provide actionable calls at The Arora Report.

Which single asset class are you most bullish (or bearish) about in the coming year?

The position I describe is a quintessential trade wrapped in red, white, and blue on optimism about America. At The Arora Report, we specialize in allocating assets on a global basis.

We highly depend on the ZYX Global Multi-Asset Allocation Model. This long-term model allocates assets on a global basis between equities, fixed-income securities, commodities, real estate, and currencies. The model further drills down to sub-asset classes, sectors, and sub-sectors.

We analyze over 100 sub-asset classes all across the world. The ZYX Global Multi-Asset Allocation Model is a highly analytical and adaptive model that uses complex quantitative techniques. Allocations are based on identifying the changes early, using the ZYX Change Method. A change means a new risk/reward ratio.

This model has successfully produced exceptional returns while taking lower risks than the markets both in bull and bear markets.

The model is most bearish on U.S. Treasury bonds. The time horizon for this call is three years.

What ETF position would you choose to best capture that?

Our pick is ProShares Short 20+ Year Treasury ETF (NYSEARCA:TBF).

How does TBF fit into your overall investment approach?

To understand how TBF fits into our investment approach let us first understand the concept behind allocation.

Arora ZYX allocation model

The model starts an allocation to an asset class or a sub-class when the risk is small, and the reward is high and increasing. Allocation is increased as there is more confirmation of the trend and the thesis. The model reduces the allocation as the risk increases even if the rewards are increasing. The model removes the allocation to the asset class as the risk goes higher, even if the rewards are going higher.

At present, out of over 100 different sub-asset classes from all over the world, the model rates TBF the highest on the risk-reward matrix.

The goal of the ZYX Global Multi-Asset Allocation Model is to produce great returns while taking less risk than the markets. The model gives precedence to risk control over potential rewards. The model is designed to maximize risk-adjusted returns over a long period of time; the model is not designed to maximize absolute returns over short periods of time. [Read more about the 10 ways the model controls risk and the factors it uses to generate actionable signals.]

So what is it that makes your model adaptable?

TBF chartThe undeniable truth about the markets is that they constantly change. The problem with the conventional models is that they may work under certain conditions, but when the conditions change, they stop working. ZYX Global Multi-Asset Allocation Model has overcome the conventional limitation as the model is designed to automatically change as the market conditions change.

The ZYX Global Multi-Asset Allocation Model is an adaptive model that uses eight distinct inter-market, macroeconomic, technical, and fund flow inputs in an adaptive mode.

The model makes two adaptations in near-real time to the eight inputs as new data becomes available. First, the weight of an input is low if the data have been choppy or directionless. However, if the data offer strong direction, regardless of the magnitude, the weight of the input increases. Second, the weight of an input changes based on its correlation with the price movement of the underlying market.

The 2008 financial crises showed that conventional wisdom of protecting a portfolio through simple diversification does not always work - stocks went down, bonds went down, real estate went down, commodities went down, and even gold went down.

Even in the biggest financial crisis since the Great Depression, our model produced a return of 42.90% compared to S&P 500 return for the period of -36.10%, while taking 50% less risk. In other words, the model produced great returns when most conventional strategies were losing money by the boatload!

We offer two variants of the Global Allocation Model: a lower-risk model that attempts to take 50% of the risk of the markets and a low-risk model that attempts to take 85% of the risk of the markets. The two variants help investors to easily customize the model themselves to suit their own risk tolerance and return requirements.

In our lower-risk model, we are not shy to hold 100% cash when risks become high, or the probability of better opportunities coming along in the near future is high. After all, cash is king when a great opportunity arises. Those already fully invested cannot take advantage of the new better opportunities.

Arora cash allocation

Such conservatism may be contrary to conventional wisdom, but there is no denying the excellent performance of this model. As shown in the chart, the model has beaten the indexes by a wide margin since inception in 2007, while on the average taking 50% of the composite risk of fully invested positions. The model puts risks before rewards, and is content missing high-risk rallies.

Arora performance

Tell us a little more about Treasurys in this maturity range. What makes this short play your highest conviction?

We start from the ZYX Global Multi-Asset Allocation Model - which is a highly quantitative data-driven model with no room for subjective opinions. As a second step, we confirm the conclusions of the model with a wide range of scenarios:

  • Global economy grows: The data are very clear that if the global economy as a whole grows at 4% or higher, we will see higher interest rates in the U.S. The higher the interest rates go, the higher will be TBF.

  • Global economy falters: The authorities all over the world are committed to preventing a double-dip recession. The data show slowing growth; nonetheless, growth is growth. But if the growth turns negative, there is little doubt that printing presses will be doing double duty, leading ultimately to higher interest rates globally. The U.S. will not be immune to increasing rates for long, because in such a scenario the U.S. dollar may start experiencing a precipitous fall. The Federal Reserve will have no choice but to raise rates and TBF will go up.

  • The U.S. economy grows: Our adaptive economic models have been predicting that both U.S. and global economic growth are slowing. Our models have been especially concerned about slowing growth and inflation in China for the last two months. Until last week, that was an uncomfortable position for us. The reason being that the conclusion of our models was in conflict with the consensus of the U.S. and the world's top economists.

    We were not shaken out because over the last several years the batting average of our adaptive models have been 100%. We attributed the differences between our position and the consensus position to two factors. We focus on leading economic indicators as opposed to coincident and lagging indicators. Second, our models are adaptive, i.e., they automatically change with changing conditions, whereas, most models used by economists are fixed and do not change until somebody decides they are not working and makes a tedious attempt to change them.

    This last week has been gratifying. The U.S. GDP data for the last quarter were revised downward on May 28. New economic data from China proved the bulls wrong.
    India just reported that its GDP grew at 7.8% vs. 8.2% consensus. Interestingly, our forecast was 7.8%.

    On June 1, ADP data showed unemployment and new payrolls far worse than expected. The economists scrambled to lower their estimates for the employment data that was to be released on June 3 by the Department of Labor - which turned out to be much worse than the revised lower estimates of the economists after the new ADP data.

    Interestingly, the actual payroll data turned out to be pretty close to our estimates from two months ago. Since our models have been so right, we have confidence in them. Our models do not show a double-dip recession. After the current slowdown, our models are predicting renewed acceleration in growth. Growth means higher interest rates and TBF price.

  • U.S. economy falters: If our models turn out to be wrong and the U.S. economy falters, the Federal Reserve is committed to using monetary policy to counteract the slowing economy. In the short run, this may hurt our position in TBF. However in the end, such loose monetary policy will lead to inflation which is good for TBF.

  • QE2: QE stands for quantitative easing, and QE2 is simply the second tranche of quantitative easing. QE is simply a technique to ease the monetary policy by buying bonds when interest rates are near zero.

    Under QE2 the Federal Reserve has been buying massive quantities of Treasurys. Two months ago, over 50% of the economists were predicting that QE2 would not end in June. We were in the minority predicting that QE2 would end. Our prediction has proven correct in that QE2 is ending now.

    The end of QE2 simply means that the Federal Reserve will not be buying a large quantity of U.S. Treasurys. The removal of a big buyer should mean lower bond prices and consequently higher prices for TBF.

  • QE3: After last week’s economic data, there is an increasing chorus of U.S. economists predicting QE3. Based on the data available so far, we disagree. Lack of a large buyer, in the form of the Federal Reserve, should be good for TBF.

  • Inflation in the U.S.: The easy monetary policy is more likely than not to result in inflation in the long run. This is good for TBF.

  • Deflation in the U.S.: This is one scenario in which TBF will get hurt, but the data so far show that the probability is relatively small.

  • Washington gets its act together: If Washington gets its act together and reins in big deficits, in the short run TBF may get hurt. In the long run, it will be a blessing. If the government consumes less, more capital will be available for the private sector to ignite growth. The growth is good for TBF.

  • Washington does not get its act together: If Washington does not get its act together, interest rates will rise. This is good for TBF.

  • Japanese buyers: Japan has been a large buyer of Treasurys. With over $300 billion of upcoming reconstruction expense in the wake of the earthquake, the Japanese are not likely to increase their purchases of Treasurys.

  • Chinese Buyers: China owns $1.1449 trillion of the $14.34 trillion U.S. debt. According to the latest numbers from the Treasury, China has reduced its holding of U.S. Treasury bills by as much as 97%. It is likely that China will reduce its holding of the long-term debt as its trade surplus shrinks.

Are there alternative ETFs that could be used to capture the same theme? What makes this specific ETF your first choice?

The cheapest way to accomplish this position is to short-sell long-dated Treasury bond futures without any leverage. However, a large number of investors are not comfortable with futures.

TBF is a good choice in that it has over $1 billion in assets and reasonable liquidity. It is also an inverse ETF, i.e., it goes up when Treasurys go down. This trade is very useful for the investors as they do not need to sell short. Further, TBF can be held in IRA, 401(k), and pension accounts.

Another popular ETF is the ProShares UltraShort 20+ Year Treasury ETF (NYSEARCA:TBT). It is a double inverse ETF. In periods of high volatility, tracking errors are more common. Therefore this ETF is less suitable for a long-term position.

Another option is to short sell iShares Barclays 20+ Year Treasury Bond ETF (NYSEARCA:TLT). In this case, investors have to deal with short selling and dividends.

Tell us about current sentiment on Treasurys. How does your view differ from the consensus?

The current sentiment is mixed. Since June 1, the sentiment is fluctuating wildly and it is difficult to say what the consensus is as of this writing.

What catalysts, near-term or long-term, do you expect are most likely to move Treasury prices?

The near term catalyst is the end of QE2. The long-term catalyst is the U.S. economy experiencing faster growth than the consensus.

What could go wrong with your pick?

If the U.S. experiences a depression or deflation, this pick will not work out.

Thanks, Nigam, for sharing your choice with us.

Disclosure: Nigam Arora and subscribers to ZYX Global Multi-Asset Allocation Alert and subscribers to ZYX Buy Change Alert are long TBF. Subscribers to ZYX Short Sell Change Alert are short TLT. Arora may also have both long and short trading positions in Treasury bond futures from time to time.

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