Monday, August 29, 2011

Not too late to buy the long bond

Have you seen the plastic smiles on some people? Their lips are smiling but the body language from the rest of the face say something else - the smile isn't genuine. That's what seems to be happening with the equity market right now. Here is the plastic smile in the form of the VIX and short-term sentiment indicators. The VIX Index spiked to over 40 - which is a sign of panic in the markets. In the past, such levels have marked intermediate term turning points for stocks. In addition, short-term investor sentiment is in bearish territory, which is contrarian bullish.

While sentiment indicators are bearish and therefore flashing a contrarian bullish signal, my cross-asset analysis is asking "Where's the fear in the rest of the market?"

When you read the headlines, the concerns that equities face today are a combination of a US recession and a European banking crisis. But if there were truly fears of a recession, then the prospect of slowing demand should cause commodity prices to go into freefall. Today, commodity prices are in a controlled downtrend but they aren't in freefall as they were in 2008.

If the markets were fearful about a European banking crisis, then the logical safe haven of choice of any size would be US Dollars. Today, the USD hasn't shown any great inclination to rally as they did in 2008.

No blood in the streets yet
To me, it doesn't sound like there is enough panic out there to warrant the assessment of a washed out market. To get another perspective, David Rosenberg wrote the following last Friday about equities:
If this is a plain vanilla correction, then a buying opportunity is likely at hand. But if we are about to enter a recession, then there will probably be another year of market weakness to endure. If there is a recession ahead, and it does look as though the odds of one are rising inexorably, then take note that only 27% of bear markets occur prior to the first month of economic contraction (in terms of the total decline from the pre-recession highs). So no matter how much the market anticipates, it is never enough at the onset - the bear phase is only a bit more than one-quarter done by the time the recession tide washes ashore.
What if wasn't just any ordinary recession but a (European) financial crisis that topples the global economy into a recession, just as we saw in 2008? If we were to look at 2008 episode as an analogy, then where are we?

In early 2008, stocks broke down out of a long multi-year uptrend on high volume (first circle). Stock prices then rallied and then weakened, with the $147 oil price marking the final top before the waterfall decline into the AIG-Wachovia-Lehman Crisis low.

Today, stocks have broken down from an uptrend dating back to the March 2009 bottom on high volume. If this were to be a repeat of 2008, could the market only be at the first break similar to the one seen in early 2008?

History doesn't repeat itself, it rhymes. The difference between 2011 and 2008 is that commodity prices have already topped out (see previous chart). The truth is probably somewhere in between. If this were 2008, my best guess is that we are probably somewhere between one-third or halfway through the decline.

A fragile Europe
It's a question of when, not if, Europe blows up. John Mauldin has written a very good summary of the problem in Europe here. The market is already showing signs of high systemic risk in the financial system consistent with a Russia Crisis or Subprime Crisis. (Incidentally, Mauldin is calling for a recession within the next twelve months and I concur with his assessment.)

The European banking system is very fragile and any minor breeze could make the whole structure topple. As Bruce Krasting pointed out, it took Drexel ten days to go under once the firm lost its funding sources. Already, the story that the ECB is tapping the Fed's USD swap lines is a serious sign of stress. How long would it take if a second or third tier European bank to go under if it got into trouble? (Less than ten days, I'll bet.) If a small bank became insolvent, then what would the contagion effects be?

What to do?
I've said this and I'll say it again. In the absence of policy intervention, the path of least resistance for equities is down. I have also shown that, based on valuation metrics, the downside potential during a panic could be as low as the 2009 bottom.

For investors and traders, the safe haven of choice remains USD denominated default-free Treasury assets. Market analysts got excited a couple of weeks ago when they pointed out that the 10-year yield was at the lows set during the Lehman Crisis panic.

Looking at the chart, I can see that the 10-year Treasury yield has more downside potential as it remains in a multi-decade downtrend. A target of 1.2% from the current 2.2% level is possible in the next few months.

The biggest bang for the bucks remains the long bond. While 10-year yields decline to the 2008 levels recently, the downside potential on long bond yields are much greater. The most recent FOMC announcement that rates would be kept low for another two years was a signal for the market to take on the carry trade - to borrow short and lend long for at least two years. This caused the yield curve to flatten in the short end but steepen in the long end. The downside potential on the 30-year is 2.0% from the current 3.5% level - a much greater capital gains potential of roughly 25% given its higher duration (and therefore higher interest rate price sensitivity of the long bond) compared to the 10-year.

My point and figure analysis of TLT, the long Treasury bond ETF, tells the same story. The point and figure chart below shows an initial target of roughly $130. If we were to calculate the ultimate target from the breakout by turning the size of the base vertically, the ultimate long-term target could be as high as $150. (For a more tactical view of TLT, see this commentary from Afraid to Trade.)

Putting it all together, the combination of my analysis of the 30-year yield and the TLT price chart both point to an initial estimate of 20-25% of potential price upside in the long Treasury bond. For non-US investors, the capital gains potential could be even greater as the USD tends to appreciate during periods of crisis.

Key risk: The scenario that I laid out depends on the absence of policy intervention, which I believe is unlikely. There is no appetite in the Congress for another round of fiscal stimulus and the Fed is out of bullets. Mohamed El-Erian of PIMCO pointed out that Bernanke said, in essence, that the Fed has done all it could and it's time for Congress to enact policies "that promote a stronger recovery in the near term [which] may serve longer-term objectives as well."

Meanwhile in Europe, EU governments are paralyzed by bickering and there is no consensus on what to do. The ECB appears to be too dogmatic to embark on quantitative easing. That's a recipe for disaster.


Tiho said...

Wow! That's ultra bearish. Thanks for the tip. Love it.

Chuckster said...

Especially in light of the upcoming 2012 elections, policy intervention, is indeed unlikely.