I don't make predictions. But, what the hell, let's see how these two trades turn out over the next year. The first is highly speculative, and individual investors aren't even allowed to do it; the second is highly defensive, and can easily be entered into by just about anybody.
The first trade is to go long the ABX subprime index. You want a specific tranche? OK, buy ABX-HE-AA 07-2 at a price of 45.
The second trade is to buy 10-year TIPS, inflation-indexed Treasury bonds, at the auction on January 10: just submit a non-competitive bid, and accept whatever the clearing price is.
If someone reminds me, we'll look back at the end of the year and see how these two trades fared, both on an absolute level and in contrast to the S&P 500.
Interestingly, the first trade has a bullish bias, while the second trade is more bearish. The idea behind going long subprime debt is quite simple: it's oversold, particularly the high-rated tranches, and they're not doing nearly as badly as you might think. Alea was kind enough to explain to me, via email, what is going on:
Floating payments are what the protection seller [buyer of the abx] has to pay to the protection buyer in case of a credit event like principal writedown , interest shortfall etc.. This is settled monthly under the so-called pay-as-you-go template.
So far there have been only "interest shortfall" payments [no writedowns !] and very interestingly the amounts have been very small. Even more interestingly they are going down, and even more interestingly some of the shortfalls have been reversed. [That means the index seller has to pay back whatever "floating payment" is reversed, because it was once delinquent, but the borrower has caught up].
This is happening, most likely, because prepayments are slowing, which means that excess spread is being collected above forecast. This excess spread allows the overcollateralization account to catch up with the losses caused by delinquencies, defaults etc. Basically there is some tentative reinforcement of the credit enhancement structure, and this is bullish for the future, if sustained. There will be a massive rally in the abx top tranches if this carries on, and you can look forward to writeups instead of writedowns for the banks marking to abx.
My view on mortgages is that we can expect pain in prime mortgages, but that most of the pain in subprime is behind us. Not in the real world of foreclosures, of course: most of that has yet to come, as adjustable-rate mortgages reset. But in the discount-the-future world of the markets, I suspect that we might have a sell-the-rumor-buy-the-news rebound when all those foreclosures start actually happening.
As for the TIPS, we've already seen that they've outperformed the S&P 500 since their inception in 1997. Looking forwards, they're likely to do even better, since they're indexed to CPI inflation, and, as any reader of Barry Ritholtz knows, CPI inflation has been artificially low of late. When it picks up, TIPS will be the first beneficiary.
What's more, TIPS are such a perfect safe haven in times of uncertainty that their real yields might even go into negative territory by year-end. If that happens, any investor in TIPS gets not only an increased coupon thanks to higher inflation, but also extra capital gains thanks to falling real interest rates.
And if you take an even bigger picture, it makes a great deal of sense for wealthy individual investors to simply park their assets in TIPS and sleep very soundly at night. Their money keeps up with inflation and then some, they have no risk of capital loss - and there's even a good chance they'll outperform the stock market. I got an email today from Eddy Elfenbein of Crossing Wall Street:
Many years ago, I had a wealthy client who put all his money in long-term T-bonds. He didn't care for anything else, and couldn't be convinced otherwise. Any [equity] premium he lost, he consider minor and not worth the headache. It's not my cup of tea, but I think he's got a point.
Stocks are within 10% of their all-time highs right now, and there's a serious risk they could fall substantially in 2008 if the U.S. does go into recession this year. (Probability: 55%, according to InTrade.) So if you are going to rotate from stocks into TIPS, now's probably as good a time as any to do so.