4 Ways Contrarians Can Play Falling Interest Rates and a Shaky Stock Market

by: ASB Capital

I share the opinion that in light of quantitative easing, rising commodity prices, and difficult (but not unsolvable) fiscal problems for the U.S. Government, treasury bond yields are way too low. Despite all that, over the last several weeks, the world has seen a certain amount of political instability, and investors seeking "safe" assets went back in to U.S. Treasuries.

When you buy a long-dated security from the United States Government at a yield of four-and-a-half percent, in a sense, you're betting that you don't think there will be a better use for your money between now and when the bond matures. If you thought you could get a higher interest rate with less risk, you would have bought that security instead, right? But some day soon, either as a result of inflation or investor dissatisfaction, treasury yields will begin to rise and the value of treasury bonds will begin to fall. Once this process starts, investors who worry about falling bond values will sell in a hurry, driving prices down further. I don't know when this will happen, but here are a few things I can do to prepare for it:

Save cash now, buy treasuries later

I think the U.S. Government is a good credit risk, but I demand to be paid a higher price for holding its securities. I'm building a large allocation of cash over time, and I will use it to start buying long-dated treasury bonds at a yield of about 6 or 6.5%. When the time comes, I expect to buy the bonds directly, but the long-term treasury ETF iShares Barclays 20+ Year Treasury Bond (NYSEARCA:TLT) may also be a good deal.

TLT costs about 91 dollars a share now, and at an average distribution of 32 cents per month, if the distribution stayed the same, I would start buying the ETF at about 70.

Short Treasuries with an inverse ETF

I also like two inverse-ETFs, ProShares Short 20+ Year Treasury (NYSEARCA:TBF) and ProShares UltraShort 20+ Year Treasury (NYSEARCA:TBT). These ETFs work through derivative contracts that track inverse of the movement of the long term bonds one day at a time. Note the fact that bonds move both up and down over time means that these indexes do not track the inverse closely over medium to long periods of time, and they can lose significant value in this way if the bond yields move "sideways" for any long period of time. TBT is a "double"-inverse ETF, so it has this problem even worse than TBF. That being said, I still think that yields are going up and bonds are going down, so I own TBT. If you think it might take a while, TBF could be a better choice.

I bought TBT over the summer and fall at prices between 30 and 35 dollars pers share. Today we're at about 38. My personal preference is to wait until bond yields fall to about 4% again, but at 4.5-4.6%, I still think TBT can be a good choice.

Buy quality, dividend paying stocks

In the "exciting" market of the last six months, nobody seems interested in the boring blue chip stocks of companies that make money every year and pay dividends like Microsoft (NASDAQ:MSFT), Johnson and Johnson (NYSE:JNJ) and other pharmaceutical names. In a falling market, however, I think income investors and others valuing safety over prospective growth will have a change of mind. When they do, they'll find that they have to pay a higher price for the steady stream of dividend income and solid financials. These companies are not subject to balance-sheet risk from rising interest rates, and they will have the ability to raise prices in an inflationary environment to cover increased costs. Today, I consider MSFT and JNJ to be great examples of this kind of company. Brand-name drug companies that pay high dividends such as Merck (NYSE:MRK), GlaxoSmithKline (NYSE:GSK) and Eli Lilly (NYSE:LLY) should do well by being able to take advantage of inflation to raise prices without facing increased costs.

Think about currencies

As U.S. Interest rates remain low, investors may be attracted to the currency of small countries with higher rates, but less of a reputation for safety. This last week, when investors went in to crisis mode, the U.S. dollar appreciated against world currencies, but then, as U.S. interest rates fell, currencies like the Australian Dollar bounced back.

For investors willing to hold risky assets, I recommend shorting the Australian Dollar against the U.S. Dollar. As U.S. interest rates rise, the Aussie will fall. My advice is don't get into currency investments unless you're willing to hold them for at least six months, no matter what. That means you can't let yourself get spooked and sell at a loss.

For everyone else, I recommend staying away from the ADRs of companies from small foreign countries that trade in U.S. Dollars. With a strong Australian and Canadian Dollar, when you buy an ADR in U.S. Dollars, you're essentially locking in a bad exchange rate. The flipside of this means that when U.S. interest rates and the U.S. Dollar appreciate, take a good look at foreign companies.

Disclosure: I am long TBT, MRK.