A Long Term Bonds Play
02/04/13 by Hugh L. O'Haynew
Filed under Uncategorized
We’re looking at a breakdown in bonds that’s pushing us toward two separate solutions – both of which should pay off handsomely if the retreat in fixed income continues.
But first let’s have a look at the bonds themselves.
From nearly every angle it’s becoming clear that there is, in fact, a rotation out of fixed income securities – particularly mid- to long-term investment grade bonds, regardless of the issuer – and into equities. We’ve been trumpeting the likelihood of this for a long time, and recent signs have confirmed for us that there’s no other explanation for what’s happening, in general, in the investment arena.
Last Friday’s trade provides a perfect example. The major stock averages were up strongly on the day, with the Dow breaking above 14,000 for the first time since October, 2007. The S&P 500, which has been setting new bull market highs for three weeks already, notched another new high Friday. Only the NASDAQ, heavily weighted by shares in Apple ((NASDAQ:AAPL), has had trouble besting its bull market highs set back in September, when Apple shares peaked at over $700. They’re now at a relatively miserable $453.
While this new equity market enthusiasm was gripping traders last Friday, the exact opposite was happening on the fixed income front.
Take a look now at three charts: the long bond, represented by the iShares Trust Barclays 20+ Year Treasury Bond ETF (NYSE:TLT); the ten year, represented by the iShares Trust Barclays 7-10 Year Treasury Bond ETF (NYSE:IEF); and the investment grade corporate sector, represented by the iShares iBoxx InvesTop Investment Grade Corp. Bond ETF (NYSE:LQD).
A few things here.
First, all three of these stocks had big drops on Friday, in particular the long bond, TLT (top chart), that fell an impressive 1.3% on the day.
TLT also lost hold entirely of its long term moving average (in yellow), and now has no immediate source of support below it on the daily chart. We’ll have more to say on this in upcoming letters.
Look now at IEF (middle chart), the ten year ETF, where, in addition to its drop on the day, we see four times the average daily volume crossing the tape (in blue). That’s the most exaggerated outflow of the three, yes, but we feel it’s symptomatic of what we’re facing in general. We also believe we’re going to see a lot more days like this (with volume) from the fixed income sector as stocks advance.
Look also at IEF’s positioning vis-à-vis its long term moving average. It’s not as dire as TLT, which looks already to have given up the ghost, but it is moving fast toward its own last line of support (in yellow).
Finally, LQD, the corporates (at bottom), which until now have been the recipient of the greatest measure of interest from bond investors (due to their superior payout), are also going to be the last to be sold, apparently.
According to LQD’s chart, there’s still one intermediate line of resistance before it reaches the long term moving average, and could therefore hold up longer than Treasuries in the event of a continued downdraft.
That said, don’t believe the corporate sector will get off easy.
Doom awaits them all. Each in his own time.
The Wave is Breaking
All told, we have a situation that is not good. All charts appear to be in the process of topping, with TLT in the worst shape of all. Three of its four MA’s have rolled over and are now trending lower. The other two ETFs are still earlier in the middle of their topping process, with price action at differing phases below their respective breaking waves.
But wait! Why should all that money go into stocks, you might ask? If, indeed, people continue to withdraw funds from bonds, why wouldn’t they just leave it in cash, or return later to Treasuries, after a brief selloff?
In the near to intermediate term, there’s simply no longer any reason not to buy equities.
With most companies reporting Q4 earnings, we find both sales and profits in corporate America are a lot better than analysts expected.
China, too, can no longer be the excuse du jour for avoiding equities. The Middle Kingdom is clearly out of last year’s funk, and growth estimates there are climbing for the first time in nearly eight quarters.
Europe, too, the sickest of the financially spastic sisters, is now out of the rut – if sovereign debt spreads are any indication.
Have a look here:
Both ugly Italy and sickly Spain have seen spreads tighten dramatically against Bonds in the last half year. That’s as good a sign of confidence as exists anywhere – and especially in debt-ridden Europe. A confidence crisis simply no longer exists on the continent.
To sum, the story is no longer American corporate growth and the potential shortfall in earnings for the fourth quarter or beyond. Nor is it China and whether she pulls out of her slump with or without a hard landing. The story is not Europe, either, where despite the absolute hole that continent has dug for itself, we see strong evidence that the worst that was expected was way too pessimistic, and where both equity markets and sovereign spreads are improving.
The story today is singular and needs little elaboration. It’s about cash flows. And there’s no longer any question that now that we’ve rounded the three corners listed above (US, China and Europe), we have only the home stretch ahead of us. And that home stretch is all about liquidity.
‘How fast’ is the only question now surrounding the money that’s now flowing toward equities. At present, velocity is middling. But it stands to gain significantly with time, in direct relation to the average investor’s knowledge of the process that’s now unfolding.
Your Trade for the Week
As we mentioned at the outset, there are two ways to play the coming collapse in bonds. The first is via TBT, the ProShares UltraShort Lehman 20+ Year Treasury ETF, an inverse, leveraged instrument that advances twice as fast as the long bond declines.
The other option – for those who also seek income – is to buy convertible securities, bonds and preferreds.
While we’re big fans of convertibles in general, we’re going to hold off on recommending them until we see a pullback that fattens up yields on these products and gives us a cheaper entry point.
Wall Street Elite recommends you purchase the TBT January 2015 35 CALLS (deep-in-the-money) for $34.40.
They’re selling today precisely one third of one percent over intrinsic.
With kind regards,
Hugh L. O’Haynew, Senior Analyst, Oakshire Financial