Long Bonds Starting to be a Buy
(June 25, 2006)
Dear Subscribers and Readers,
We entered a 50% long position in our DJIA Timing System on Thursday morning, June 8th at a DJIA print of 10,810. We then became more aggressive and shifted to a fully 100% long position on the morning of June 12th. In a real-time email that we sent to our subscribers, I noted to our subscribers: “We have just shifted from a 50% long position to a 100% long position in our DJIA Timing System at DJIA 10,800. The NYSE intraday ARMS index just touched a hugely oversold reading of 2.46 while the VIX spiked up another 15%.” Based on Friday's close of 10,989.09, our 100% long position in our DJIA Timing System is on average 184.09 in the green. Again, readers who are interested in our historical signals can see more (and learn about our rationale behind those signals) at our MarketThoughts DJIA Timing System page.
As of Sunday evening, June 25, 2006, this author still has no intention of shifting our 100% long position in our DJIA Timing System – unless the decline over the last seven weeks resumes or accelerates. There is a good chance that the market had already hit an intermediate bottom at a DJIA print of 10,706.14 at the close on the Tuesday before last (June 13th). At the same time, however, this author recognizes that anything can happen in the markets – especially given an over-eager Fed and continuing tightening from both the ECB and the BoJ – and as such, we have placed a stop on our 100% position at our average entry point – 10,805 – in order to avoid the possibility of a crash. That being said, the time window for a crash is getting narrower by the day. If the market does not exhibit any significant weakness by early this week, then chances are good that the market has already hit an intermediate bottom.
Before we go on with our commentary, let me first pose a question that has been popular with many of our subscribers as well as many other traders (professional and amateur alike) out there. That question is: So you want to start your own hedge fund?
Many of our subscribers have emailed me over the last 12 months asking for “advice” on how to start their own hedge funds (we manage a small one for family and friends) – including how costly it is to start one, and how realistic it is to attract a significant amount of funds. For folks who are sincerely wishing to serve your potential investors, I highly recommend reading Barton Biggs' latest work called “Hedge Hogging.” In the book, Barton Biggs covers many different topics that would be of interest to the potential hedge fund manager – such as the difficulty of raising funds, the fickleness of hedge fund investors, and most importantly, the difficulty of achieving long-term, consistent, investment success. Bottom line: This isn't supposed to be easy.
Obviously, this author doesn't have all the pieces – but just as with every endeavor in life – this author believes that one will need to get any edge he or she can in order to ensure long-term success in the hedge fund industry. That means getting the necessary education (MBA or PhD in a top 20 school), the required professional experience – and most important of all, the necessary connections in order to keep abreast of the latest trends and popular trades. As the hedge fund industry increases in size, the number of opportunities and inefficiencies are getting squeezed out of the financial markets – and chances are that if you are a one-man team working out of your garage (so to speak) without the appropriate “hot line” to your former partners at Goldman, you will definitely miss out on them. In the world of currency and bond trading (as well as stocks trading all around the globe aside from the U.S., Japanese, and Western European markets), insider information and having local connections is the key. You need to be able to use them if you want to achieve long-term success in the hedge fund industry.
But Henry, what do you mean? I have achieved an outstanding personal record over the last six years since the bursting of the technology bubble – why can't I utilize this record and raise money from high net worth individuals or even institutional investors?
Sure you can. First of all, you will need to get a thorough audit of your trades from a Big Four accounting firm. Did you achieve your returns with little downside volatility? How many strategies did you implement during that time? Were you diversified across those trading and investing strategies – or did you just have all your money in gold and energy? Would trading ten times the amount of your money be a problem if you had been trading in microcaps? Are there checks and balances in your trading, or are you essentially a one-person team? While institutional investors are definitely more stringent in their manager selections (yours truly will be responsible for some of that going forward), there is a good chance that how high net worth individuals will be going forward as well – especially given the proliferation of funds of funds (who charges a fee by picking hedge fund managers for their clients). In other words – unless you're managing your own family's money – it can be a very difficult task to attract investors into your hedge fund (and have them remain in there) if “all you have” is a good track record.
Interestingly, attracting money is probably the easy part – as this author believes that achieving consistent, positive, and above-market returns is the difficult part. I have many folks who have written to me telling me that they are contrarians and have side-stepped the technology bust of 2000 to 2002 and that they have made a lot of money buying and holding precious metals and energy stocks over the last few years. That is all fine and good, but please note that these positions are not all that unique. The late 1990s and the subsequent technology bust had a lot to do with the lax liquidity conditions in the late 1990s and the subsequent mopping up of that excess liquidity. This was not too difficult to see. Many investors foresaw that and took advantage of the subsequent flooding of liquidity in 2001 to 2003 as well. Make no mistake: It is not going to be so easy going forward. Buying gold and energy in 2003, 2004, and 2005 was akin to buying technology stocks in the late 1990s. In a lax liquidity environment, everyone is a genius. As Warren Buffett stated, you will only find out who has been swimming naked when the tide recedes.
I do not mean to discourage those who want to start a hedge fund. My words are supposed to serve as a reminder on how dangerous the markets could be. If you are passionate about the markets, don't give up on starting a hedge fund – be tenacious - but please, give it a little bit more time and study everything you could before doing so. For most people, you only get one shot. A good book to read regarding the current state of the hedge fund industry is “Inside the House of Money” by Stephen Drobny. If you think you are an out-of-consensus trader, check out some of the ideas (such as index-linked housing bonds in Iceland) that are discussed in the book.
Let's now get on with our commentary. We last had a significant discussion of the U.S. long bond in our March 12, 2006 (“Rising Rates Now a Given”) commentary. In our March 12, 2006 commentary, I stated that while the 30-year yield was sitting near the top of its 18-month trading range, it was definitely not the time to buy bonds. Following is the chart of the 30-year bond yield (courtesy of Decisionpoint.com) that I had posted at the time:
Please note that the yield of the 30-year long bond closed at 4.74% on March 10th. Since that time, it has risen an additional 48 basis points to close at 5.26% as of last Friday. Short of a bad central bank policy or a prevailing U.S. protectionist sentiment, the yield of the long bond should stay relatively low for the foreseeable future. Assuming that this is the case, the current yield of the long bond at 5.26% is definitely “overbought.” Following is an updated chart of the yield of the 30-year long bond courtesy of Decisionpoint.com:
In our March 12, 2006 commentary, I also discussed the historically high correlation of the yield of the 10-year Japanese government bond and the yield of the 10-year U.S. Treasury note. In that commentary, I asserted that with the gradual unwinding of the Bank of Japan's quantitative easing policy, the yield of the 10-year JGB would surely rise – and thus putting upward pressure on the 10-year Treasury yield in the process. Since that commentary, the Bank of Japan's QE policy has now ended. At the same time, however, both the Ministry of Finance and the Bank of Japan have been very careful with shoring the system with liquidity – by periodically injecting the banking system with overnight reserves and with making sure that the rise of the yield of the 10-year JGB does not get out of control. As a result, the yield of the 10-year JGB has never effectively risen over 2% since the end of the QE policy on March 9th. This correlation can be witnessed in the movements of the 10-year Japanese government bond yield vs. the 10-year U.S. Treasury note from March 2001 to the present:
Given that the yield of the 10-year JGB has stayed relatively benign, the chances of a further rise in the yield of the 10-year U.S. Treasury note are definitely not high. In fact, the differential between the yield of the 10-year JGB and the 10-year U.S. Treasury note is now at its highest since June 2002 – suggesting that U.S. long bond (10-year as well as 30-year) should decline going forward even as the yield of the 10-year JGB fails to decline from current levels. Combined with the fact that the U.S. economy is in the midst of slowing down (as discussed by this author in January of this year and now confirmed by the ECRI weekly leading index), and there is no way but for yield of the long bond to come down. We are now getting bullish on the long bond for the next three to six months.
That being said, timing is always of the essence, and this author does not feel that this is the perfect time to go long the long bond just yet. While there can never be a “perfect scenario” for going long or short, this author believes that the following three primary reasons should give the long bond investor pause for now:
1) The fact that the Federal Reserve will again hike the Fed Funds rate on June 29th by at least 25 basis points. Such a move should also exert continuing upward pressure on the yield of the long bond – as has been the case for the last six months. Moreover, yield curve flattening trades among hedge funds are no longer popular – and in fact, chances are that the hedge funds are now betting on a steeper yield curve and will thus continue to sell the long bond as long as the Federal Reserve is hiking.
2) Sentiment of the U.S. long bond is not overly pessimistic at this stage, as exemplified by the Rydex Bond Ratio (bearish assets on bonds divided by bullish assets on bonds) and the latest Commitment of Traders Report on the U.S. Treasury bond futures. Following is a three-year chart (courtesy of Decisionpoint.com) showing the Rydex Bond Ratio vs. the 30-year Treasury yield as well as a 12-month chart (courtesy of Softwarenorth.net) showing the Commitment of Traders data for the U.S. Treasury bond futures:
As illustrated by the two above charts, the sentiment data on the U.S. long bond is not overly pessimistic – certainly not as pessimistic as previous readings that were consistent with prior peaks in the yield of the long bond. This is also confirmed by the relatively neutral reading on HBNSI (the Hulbert Bond Newsletter Sentiment Index). The last I heard, the reading was at negative 3.2% last Monday – compared to a highly pessimistic reading of negative 41% as late as May 19th. Bottom line: Sentiment wise, we are definitely not there yet – and we won't probably get there until the yield of the long bond rises another 20 to 30 basis points from current levels.
3) Finally, given that this author is intermediate-term bullish on the stock market, I just cannot envision a scenario where bond yields will just decline from current levels at the same time the stock market is rising. I have previously stated that we have most likely bottomed (on a DJIA basis) on June 13th – and that this current rally should last another four to eight weeks. Based on the action of the stock market, a “buy signal” for bonds will most probably not emerge until late July at the earliest.
From this point on, this author will assess the long bond situation on a daily basis. For now, subscribers should just keep the long bond on their radar screens. Based on our current assessments, this author believes a buy point will come on the long bond at a yield 20 to 30 basis points higher than current levels or by late July to early August – whichever one comes first. But given that the situation is still very much in flux (for example, there could be one more Fed Funds rate hike on August 8th should the stock or commodity markets continue to propel higher), this author will reevaluate on a daily basis. Subscribers, please check our discussion forum for the latest updates going forward.
Let's now turn our sights on the stock market – starting with a comment on the NYSE ARMS Index. In our commentary last weekend, we dissected the most recent readings of the NYSE ARMS Index and the possible implications. More specifically, we conjectured that the strong one-day reading of 0.19 on June 15th – coming on the heels of a hugely oversold 10-day reading of 1.52 – suggests that the market made an intermediate bottom on June 13th. The readings of the NYSE ARMS Index over the last week further suggest that we made an intermediate bottom on June 13th. I will discuss why in a minute, but following is the daily chart showing the 10-day and the 21-day moving average of the ARMS Index vs. the Dow Industrials from January 2003 to the present:
As mentioned on the above chart: With the current 10-day and 21-day moving averages of the NYSE ARMS Index at 1.11 and 1.20, respectively, the market has now gotten out of the “danger zone” in terms of the potential for a crash (since all crashes occur while the market is oversold). At the same time, such readings also do not imply an overbought situation – suggesting that the market has more potential to rise from current levels.
The latest NYSE short interest numbers are also confirming that an intermediate bottom has been made or is in the midst of being made (I know I promised last weekend, but the latest margin debt numbers are still not available yet). For the month ending June 15, 2006, total NYSE short interest increased 471 million shares to 9.08 billion shares – breaking the all-time high set for the month ending November 15, 2005. Following is a monthly chart showing the NYSE short interest vs. the Dow Industrials from November 15, 2000 to June 15, 2006:
After a brief pause during the December 2005 to February 2006 period, the NYSE short interest has come back with a vengeance – rising a total of 10.2% over the last three months. Such a rise represents the greatest rate of NYSE short interest since September 2002. From a contrarian standpoint, this suggests that the market has or is in the midst of making a significant bottom, especially given the record earnings and cash levels of U.S. domestic companies. In other words, there are many “investors” out there who are willing to “earn” a negative carry in exchange for hoping for a crash of U.S. domestic equities (as opposed to during the 2000 to 2002 period when many companies had negative cash flows). In such a scenario, short-sellers are most likely to cover as soon as they see that a crash is not on the table – and thus further driving up stock prices.
The following insider selling and buying information of all U.S. domestic companies from Thomson Financial also suggests that we have made an intermediate bottom on June 13th:
Please note that the insider sell/buy ratio for June is currently 7.92 – the lowest reading since the 7.4 reading of last October (the last significant bottom). More importantly, the value of all insider selling for the month of June thus far ($3.76 billion) – even when adjusted to a monthly basis – is the lowest reading we have seen in a long time. For comparison purposes, the value of all insider selling for October 2005 was a relatively high $5.29 billion (not shown). Given that the propensity for insiders of U.S. domestic companies to unload their own shares is at the lowest in months, chances are again high that we saw an intermediate bottom in the stock market on June 13th.
Let's now take a look at the most recent action of the Dow Industrials vs. the Dow Transports, as shown by the following chart from July 1, 2003 to the present:
For the week ending June 23, 2006, the Dow Industrials declined 25 points while the Dow Transports rose 137 points – resulting in an upside non-confirmation by the Dow Industrials. The bears would point to this and claim that the Dow Transports is in further need of a correction, but given that the Dow Transports has been leading the Dow Industrials (and other major market indices) since the beginning of this cyclical bull market in October 2002, probability implies that the Dow Transports will ultimately “pull up” the Dow Industrials along with it – further suggesting that we have already seen an intermediate bottom on June 13th. Again, I believe the current bounce should last for another four to eight weeks. For now, we will continue to maintain a 100% long position in our DJIA Timing System. However, since no indicator is infallible, we will also put in a stop at our average entry point of 10,805.
I will now end this commentary with a quick discussion of our popular sentiment indicators – those being the bulls-bears percentages of the American Association of Individual Investors (AAII), the Investors Intelligence, and the Market Vane's Bullish Consensus Surveys. The latest four-week moving average of these sentiment indicators declined further from 2.7% to 1.7% in the latest week – again, a low not seen since April 2003! This reading has now convincingly surpassed the oversold levels that are consistent with short-term bottoms in the markets over the last few years. More importantly, the fact that this reading continues to get more oversold even as the markets bounced over the last two weeks is a good development for the bulls, as rallies will only be sustainable if they climb a “wall of worry.” Following is a weekly chart showing the four-week moving average of the Market Vane, AAII, and the Investors Intelligence Survey Bulls-Bears% Differentials from January 1997 to the present week:
Conclusion: Based on the readings of the NYSE ARMS Index, the NYSE Short Interest, the latest insider selling and buying information, and based on the current sentiment backdrop, chances are good that the June 13th low represented an intermediate bottom for the stock market – a low which should provide a basis for a rally lasting a further four to eight weeks. As for the Fed, this author still maintains that the Fed will hike one more time on June 29th, although another hike is likely on August 8th if both the stock and the commodity markets continue to propel higher from current levels. While the combination of higher borrowing costs and additional supplies coming into the markets should put a lid on crude oil and commodity prices in general, anything can happen in the short-run – and as a result, we would not be surprised to see Bernanke to continue to overshoot on his latest rate hike campaign.
Finally, a “buy signal” is now in the works for the U.S. long bond. While we are most probably not there yet in terms of timing, readers should continue to monitor the long bond (and their favorite bond fund) going forward – as this author definitely sees a profitable trade in going long the long bond sometime in the next four to six weeks. Subscribers please stay tuned.
Henry K. To, CFA