Most Investors Miss The Point: Operation Twist Is Brilliant

by: Nigam Arora

The media is full of criticism of Operation Twist. There is nary a glimpse of an analysis based on data.

There is no doubt that the way to become popular is to write an article that helps a vast majority of people justify their opinion. Unfortunately, money is not made by forming opinions first and then justifying them with data. The way to make money is to start with no opinion, analyze the data, and then let a proven framework such as the ZYX Change Method draw the conclusions objectively.

Most investors have missed the point. The U.S. housing market is on the cusp of another 10% price decline. It is like standing on a ledge high above the ground. It does not take much to fall to certain death or to be pulled back to safety. It is true that Operation Twist will not do much for most of what ails our economy, but it is more than enough to pull the U.S. housing market to safety.

Without the Fed’s action it is likely that a new down leg in house prices would have a disastrous effect on our banking system. Our banking system simply cannot survive another big decline in housing prices. This would have been worse than 2008. In 2008, Europe and Asia were in good shape. The President and Congress in Washington were also able to act. Now Europe is on the brink of a major financial crisis and Asia is slowing down. The government in Washington is impotent.

Imagine what would have happened in 2011 without Fed action!

In 2008, we went 100% short with housing and financial shorts dominating. In 2008, while most investors were losing money, our models made money by the boat load. In the absence of Operation Twist, our models would have again gone heavily short on financial stocks. However, with Operation Twist, a different strategy is called for.

Before a discussion of how to make money in this environment, let us understand Operation Twist. The best way to understand is to directly read the statement from the Federal Reserve. Excerpts from the statement follow:

To support a stronger economic recovery and to help ensure that inflation, over time, is at levels consistent with the dual mandate, the Committee decided today to extend the average maturity of its holdings of securities. The Committee intends to purchase, by the end of June 2012, $400 billion of Treasury securities with remaining maturities of 6 years to 30 years and to sell an equal amount of Treasury securities with remaining maturities of 3 years or less. This program should put downward pressure on longer-term interest rates and help make broader financial conditions more accommodative. The Committee will regularly review the size and composition of its securities holdings and is prepared to adjust those holdings as appropriate.

To help support conditions in mortgage markets, the Committee will now reinvest principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities. In addition, the Committee will maintain its existing policy of rolling over maturing Treasury securities at auction.

The Committee also decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that economic conditions–including low rates of resource utilization and a subdued outlook for inflation over the medium run…

With a three year horizon, there are several ways to make money:

Short sell U.S. Treasuries.

The best way is to short sell futures. However, those not inclined to short sell futures can consider buying inverse ETFs such as TBF and TBT. Another option is to short sell ETFs such as TLT.

Buy U.S. Equities.

An easy way is to buy ETFs such as SPY, SSO, QQQ, and QLD. A better way is to buy stocks or sector ETFs that are quantitatively inexpensive.

Short sell Commodities.

The best way is to directly short sell copper, nickel, zinc, and coal. An option is to use inverse ETFs.

Short sell Gold and Silver.

One way is to buy inverse ETFs such as DZZ, GLL, and ZSL. The other option is to short sell GLD and SLV.

The best returns with the lowest risk will be achieved by taking a portfolio approach using the right ETFs and the right individual stocks in proper proportion.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: I am short on GLD and long on TBF. I also have a number of other positions both on the long and short side that will fall within the strategy above.