Nicholas Cavallaro's  Instablog

Paradox

Last month, S&P downgraded the US’s sovereign credit rating from AAA to AA+ (with a negative outlook).  Since then, the US 10yr Treasury Bond yield has fallen from 2.40% to 1.99%.  This means that as US credit is officially considered to be worsening, more investors are buying it!  The opposite is normally true:  when a country is downgraded, investors normally demand higher compensation for lending funds to that country.  In the US’s current situation, the country suffered a downgrade and investors now demand less compensation for funds lent–quite the paradox!  I believe this situation to be unsustainable.

Implications

Suppressing interest rates to abnormally low levels both hurts the economy and the currency.  My assumptions are as follows:

• An economy is based on what it produces
• New sources of production depend on businesses investing in capital expenditures
• Financing for capital expenditures depends on another party saving money (forgoing consumption)
• Saving money requires an incentive of high interest rates

AND

• Printing money to enable low rates (via purchasing treasuries) devalues the currency
• A devalued currency appears as broad-based inflation with increased commodity prices

Today’s Trade

 I argue that the economic malaise, devalued currency, or both, will not be tolerated over the next few years.  I have already established investment positions for an economic downturn, and I have multiple positions that hedge against the US Dollar (see Commodities and Coins allocation in this pie graph).  Today’s trade directly attacks the yield curve.  I strongly believe that the US 10yr Treasury Bond will yield significantly higher than 1.99% in a few years.  I choose to short the 3-7 year portion of the curve by shorting 15 shares of IEI, which is a bond fund ETF mimicking the Treasury Yield curve, at $121.70.  Ideally, I would have like to have also shorted IEF, which is the 7-10 year portion of the curve, but shares of the ETF were unavailable for shorting; I may revisit this next week…  And for those of you who are long-time followers, I still own JFR and would consider purchasing more at a lower price.

This market has truly fascinated me over the past eighteen months.  The economy has, and will continue to spin its wheels as production and savings remain weak.  Meanwhile, equities remain on a tear, inflating a bubble that has unfortunately expanded since I last touched on the subject a year ago.

Given this, along with a meaningful short allocation, I am implementing present trades that are somewhat market neutral.  Paired trades, which take both long and short positions, have a low correlation to the stock market’s performance.  An example of this was the housing trade executed last month, when I bought NVR and shorted a handful of other homebuilders.  Today, I focused on purchasing stability and selling risk.

At the end of last year, John Hussman argued that risky trading strategies (market beta, momentum, style sensitivity) clearly benefitted over the previous quarter while value stocks dawdled.  This trend has continued.  Hussman further demonstrates that value wins out over time since stock investors own assets that produce future cash flows.

A profit can be made from this situation by selling risk and concurrently buying value.  Selling risk implies betting against companies that thrive when businesses expand.  These types of stocks are considered cyclicals, or industrials (I’ll use these synonymously).  Some examples include General Electric GE, United Technologies UTX, and UPS UPS.  Buying value implies buying companies that sell household products that consumers purchase regardless of the economic cycle.  These include Proctor & Gamble PG, Wal-Mart WMT, and Philip Morris PM.

Now, for me to engage in this paired trade, I would like see additional evidence that risk has beaten value.  This can be depicted in two ways.  First, Bill Hester constructed a graph that shows the rise of cyclicals to staples both over the past two decades.  Second, as shown below, ETF proxies confirm the disparity trend over the past full market cycle.

To represent consumer staples, I’ll use the Consumer Staples Select SPDR XLP, and to represent the cyclicals, I’ll use the Industrial Select Sector SPDR XLI.  The time frame parameter I choose to focus on is October 2002 through March 2009, the last two equity troughs.  From trough to trough, the chart shows that staples returned approximately zero and industrials fell by almost 20%.  Since then, industrials has soared to 99% while staples has barely kept up half the pace.  I’m betting that the subsequent fall of industrials will be much greater than the fall of staples.  We’ve seen this movie before.

(image from Google Finance)

Since I can reliably show that value wins over time, both in theory and in practice, and I’m willing to take this trade at this point in time.  Today I purchased 65 XLP at $29.50 and shorted 55 XLI at $37.79.