One Patriotic Way to Profit in the Next 3 Months
Thursday, July 2, 2009 | Price HeadleyRating:
As we head into the long July 4th holiday weekend (remember, the markets are closed on Friday), I'm reminded of what it means to be "patriotic." Merriam-Webster defines patriotism as a "love or devotion to one's country." I saw another definition I liked even better, which is a desire to improve one's country and make it better. In my own investments, I don't want to be blindly devoted to a position, but rather do my best to improve my portfolio by cutting losers quickly while letting winners run. This gives me much more opportunity to increase my impact on the causes that I think are worthy to improve our nation, while not being stuck in non-performing positions just based on some ill-founded blind hope.
To Serve and Protect ... Our Portfolios
As investors, there have been plenty of questions about where the USA is headed, with billion-dollar deficits and mounting job losses concerning everyone about the economic outlook. But there's a case to be made for a patriotic play in the coming months to benefit from the overreaction of the markets to the recent spate of inflation-driven worries: that's to consider buying October call options on the long-term U.S. Treasury bonds, via the iShares Barclays 20-Year Treasury Bond (TLT).
The TLT has been ravaged by worries that the U.S. government's policies to spend now and pay back later will result in more money creation and, thus, more inflation down the road.
Frankly, on a multi-year outlook, I can't disagree with this expectation. But as a trader, I see an opportunity to bet that the bond market has overreacted and will actually improve in the coming several months before things get worse.
Here are my top three reasons why I expect a bounce in bonds and a dip in interest rates into mid-October, which should bring the TLT back up to my target of $100 to $101 (vs. the current price at $94, though I like TLT calls better between $91 and $92 in the next few weeks hopefully, so I haven't bought these calls just yet, but I want you to be aware of what I'm stalking):
1) Expectations of a Fed rate hike in late 2009 or early 2010 are overblown -- We all know that job creation in the USA is stalled thanks to the abundance of cheaper labor overseas and the stifling burdens placed on employers in the United States. Yet, recently there's been a lot of talk that the Fed will have to raise short-term Fed Funds rates to combat growing inflationary concerns later this year or early next.
During the past week, the December 2009 Fed Funds futures have implied a range between a 37% to 56% chance that the Fed will raise rates from the current target of 0 to 0.25%, up to 0.5%. I think that's relatively unlikely, unless the prospects for a strengthening economy or runaway inflation were to emerge.
I just don't see either of those scenarios happening in the coming six months, as broader-based economic weakness will depress the stimulative attempts by the government for now.
(Those last two words are the key words, as runaway government spending to come will likely eventually have its desired effect in 2010 and beyond.)
2) TLT will benefit from safe-haven buying of bonds as investors move out of stocks in the seasonally weak September-to-October period.
Everyone knows that bonds tend to benefit when stocks are weak, as portfolio managers will seek the relative safety of bonds to preserve capital while stocks are dropping. This "flight to quality" occurs in the short run if stocks sell off, even if investors are worried longer-term about inflation.
This is simply due to the fact that fund managers have to buy something, they can't just shift to 100% cash. (Otherwise, why would investors pay their management fees to sit on cash?) So, the TLT benefits clearly if U.S. stocks sell off as I expect in September and October. (Believe it or not, September has historically been the worst month for stocks over the last century, despite well-publicized October crashes.)
3) TLT money flows point to an uptick in coming months -- The weekly chart below shows that when TLT gets this oversold (as measured by the stochastics oscillator), and it then turns up to signal an end to the selling pressure, there's usually a meaningful recovery in bond prices ahead.
The last two times we saw a similar pattern to the current weekly upturn in TLT's stochastics were in July 2007 and July 2008. Interesting timing that each of the last two summers was a good time to be moving into bonds, eh? It fits with the seasonal stock weakness and, thus, the theme about bonds being a safe haven, at least in relative terms.
During the past week, the December 2009 Fed Funds futures have implied a range between a 37% to 56% chance that the Fed will raise rates from the current target of 0 to 0.25%, up to 0.5%. I think that's relatively unlikely, unless the prospects for a strengthening economy or runaway inflation were to emerge.
I just don't see either of those scenarios happening in the coming six months, as broader-based economic weakness will depress the stimulative attempts by the government for now.
(Those last two words are the key words, as runaway government spending to come will likely eventually have its desired effect in 2010 and beyond.)
2) TLT will benefit from safe-haven buying of bonds as investors move out of stocks in the seasonally weak September-to-October period.
Everyone knows that bonds tend to benefit when stocks are weak, as portfolio managers will seek the relative safety of bonds to preserve capital while stocks are dropping. This "flight to quality" occurs in the short run if stocks sell off, even if investors are worried longer-term about inflation.
This is simply due to the fact that fund managers have to buy something, they can't just shift to 100% cash. (Otherwise, why would investors pay their management fees to sit on cash?) So, the TLT benefits clearly if U.S. stocks sell off as I expect in September and October. (Believe it or not, September has historically been the worst month for stocks over the last century, despite well-publicized October crashes.)
3) TLT money flows point to an uptick in coming months -- The weekly chart below shows that when TLT gets this oversold (as measured by the stochastics oscillator), and it then turns up to signal an end to the selling pressure, there's usually a meaningful recovery in bond prices ahead.
The last two times we saw a similar pattern to the current weekly upturn in TLT's stochastics were in July 2007 and July 2008. Interesting timing that each of the last two summers was a good time to be moving into bonds, eh? It fits with the seasonal stock weakness and, thus, the theme about bonds being a safe haven, at least in relative terms.
TLT Weekly Chart with Fast and Slow Stochastics
Frankly, the chart will tell the true tale. You can see massive support on TLT down near $90, which is why I prefer to buy TLT calls closer to this support, with a buy zone between $91 and $92 being acceptable in my view. That's because my target is for a move back to the prior support around $100 to $101.
So a buyer at $92, with a sell stop at $89, could risk 3 points to make 9 points up to $101. Anytime I can find a reward-to-risk ratio of 3-to-1 or higher, it catches my attention, and should catch yours as well.
It Can Pay to be Patriotic
Regardless of your long-term beliefs, it helps to look at the charts to tell you what the markets are saying. There's an old maxim among traders that still rings true: "Trade what you see, not what you believe."
By the time other investors and portfolio managers are scrambling to get out of stocks after the July earnings season confirms weaker-than-expected numbers going forward, you can be ahead of the curve with the shift back to the relative safety of the U.S. bonds via the TLT.
Certainly it's a contrarian idea in the current environment, but some of my best trades have been against the commonly held views of the time. As investor perceptions change, the variant perception that was just ahead of the crowd gets rewarded the most.
Just remember, it can pay as an investor to be patriotic if it improves your situation and allows you to help others in return. And if it's not paying off, don't be blind to what the markets are telling you. The charts don't lie.
Have a happy and safe Fourth of July!
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Price Headley
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