As Bernanke came to the aid of the markets, refusing to pull away the stimulus, I wanted to write a short analysis about which investment would have the best risk/return characteristic to play this boost. I should caution the analysis here is only for implementation until late May 2012. With the markets so overextended the start of the summer 2012 might have some surprises for investors.
It turns out the best risk/return combination is in oil (USO). Surprisingly, oil's superiority over other investment choices is not a result of reasons to go long. It is rather, the lack of certain risks compared to other alternatives that makes it a better choice.
Here is a list of the reasons that make oil the best trade, in my opinion, to play the Bernanke boost:
- The main reason is, with the markets so overextended, many assets are riding out the positive market mood rather than fundamental reasons. Oil seems to be the only asset that is supported by a real supply/demand dynamic.
- The most obvious alternative to oil is equities (QQQ). However, if you invest in equities you expose yourself to various extra risks. Chances are the company that you invest in will be reporting its earnings in the next 2 months. With so many stocks way overextended, any mishap in the earnings report might hit your investment quite hard. However, it is not easy to short the overextended stocks either. If the market mood is positive, investors can get extremely creative in putting a positive spin on even the most horrible earnings miss.
- EUR/USD cross (FXE) or European stocks might seem a good choice, since more easing means a higher EUR. However, with the Europeans also in easing mode with the LTRO, it is just a guessing game which currency will depreciate more. You can check out my in-depth analysis of the Euro and European markets here: Euro: The Currency That Defies Supply and Demand?
- Precious metals -- (GLD), (SLV) -- are an alternative which moves roughly on the same mechanics as oil. However, precious metals, especially silver, are more volatile than oil. In the case of a revival of the European problems, they might be subject to a severe correction, whereas oil would be supported by industrial demand.
- Bonds are a viable alternative, I will admit. In fact, they may be the next best thing to oil. After the Bernanke remarks the bond yields will definitely be pressured down from their recent rise. You can check out my in-depth analysis of that subject in "Bernanke Is Still The Emperor, Bonds Are Still A Buy"
You should also be aware that oil simply has the best risk/return tradeoff. This does not ensure that oil will be immune to a turn in market sentiment. Financial assets and commodities are very highly correlated. Oil will be the most resilient in a possible market turn from the overextended levels but it still might take a modest hit.
You should also be content with about a 10% - 13% return if you invest in oil. In my opinion, that is the maximum upside you can expect in two months. If you want to play for higher returns, you might need to invest in momentum stocks like cloud companies. However, the risk does not justify the returns in those momentum stocks, in my opinion. Instead you can just take a leveraged position in oil and you would still get a better risk/return combination.
Disclosure: I am long USO.