Long Bond Capitulation?

By: Henry To | Tue, Jun 7, 2005
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Dear Subscribers and Readers,

Please note that we switched from a neutral position to a 100% long position in our DJIA Timing System on the morning of May 5th at DJIA 10,395. For now, we will continue to hold until further notice. The secondary trend is now murky - and so we will be keeping a very close watch on our 100% long position in our DJIA Timing System over the next couple of weeks or so.

I hope everyone has had a good weekend. Part of my weekend was spent pondering the current situation of the stock market and the bond market - and how they may affect my subscribers' well-beings. What happens to the stock market if the US$ continues to climb? How come oil is still over $55 a barrel even as the US$ has rallied and even as current inventory levels are over their previous five-year highs? Cyclicals should lead the stock market down. Steel has gone down, and the CRB Index has declined nearly 10% from its high. What of oil and copper? How about homebuilding stocks? Google has been the one stock that has been rising nearly day after day. Recently, two analysts slapped a $350 target price for GOOG - which will ultimately give the stock a $100 billion market cap. Even at today's market cap of $80 billion, Google is worth more than "the combined values of New York Times Co., Dow Jones & Co., Tribune Company, and Walt Disney,"; as pointed out by the following Marketwatch.com article. Why isn't the long bond declining in price even as the Fed raised the Discount and the Fed Funds rate eight times since June 2004? Does the decline in the yield in the long bond signal a slowing economy going forward - even a recession? If so, why isn't the stock market tanking?

All this is definitely overwhelming. It gives me a headache even as I think about it - let alone the average blue collar worker who is just given an option to invest by his or her company's 401(k) plan without any formal training. True, the venture capitalists and the company insiders don't care. Dumping stocks that are going down in price when you had an option to purchase those shares at one dollar per share probably won't hurt your pocketbook too much (I'm sure the Google insiders are not kicking themselves too much just because they sold some of their shares at $200 a share instead of $280 a share). But what of the average retail investor or the hedge fund manager? How can we make sense of the thousands of variables that could potentially affect our stocks, bond, commodity, and gold portfolios? And I have only discussed macro variables. What if one is invested in certain industries or certain individual stocks? How do we evaluate management? How do we know earnings are legitimate?

To help my readers out, let's first go back to basics. In many of my past commentaries, I have stated that the key to successful investing is the ability to successfully think through the many scenarios that are possible for the stock market and for the economy - and then successfully gauging how likely each scenario will occur. This is more art than science. It requires a broad knowledge of the financial markets and financial history, a good sense of how the markets have evolved over time, and also some knowledge of geopolitics. As for me, I just try to make it as simple for my readers as possible. The fewer variables we have to deal with, the better (and as some of my subscribers will say, the shorter my commentary the better!).

With that said, I will try to write a shorter but more concise commentary in the following paragraphs. It is to be said here that in the current environment, we should really only go for the ultra-high probability plays. Well, we should do so in all our investments, but the current environment is even more important. Why am I saying that? Readers may recall our "big signal"; on our DJIA Timing System on May 5th at a DJIA print of 10,395. My day-to-day entries are usually pretty lousy - that is why I mostly pay attention to weekly trends or even monthly trends. At the time of our signal, I believed that the stock market environment has taken a turn for the best (for the bulls). That is, bad news was being bought and supply was minimal. There was one caveat - I also believed at the time that the rally going forward would be relatively narrow and that if one buys the wrong stocks, then not only will he or she see minimal gains but that they may also turn into losses. At the time, I recommended our readers to buy the large cap growth/brand name stocks such as KO, SBUX, MRK, HDI, YHOO, EBAY, and INTC. With the exception of MRK and HDI (which was essentially flat from May 5th), all of those stocks were either slightly up or performed very well. At the same time, the DJIA is only up a mere 65 points - an index which *should* more or less participate in all major stock market rallies. My recommendation of the large cap growth/brand names was what I thought a high-probability play at that time. After the latest rally, these stocks are not really high-probability plays that they used to be. Despite the still-oversold condition of the major stock market indices, I believe that now is probably the time to start trimming your positions and to adopt a more defensive stance.

Okay Henry, so what do you think is a higher-probability play nowadays? Are you still bullish on the US$? Yes, I am. I said the dollar index was a "buy"; at 84 and change. As I am typing this, the dollar index stands at around 88, and I think it still has further room to go until we hit the 90 to 95 range. While this is still a relatively high-probability play, the reward is definitely not as high as it was only a month ago. I hope my subscribers have taken advantage of these recent "mini trends"; but if not, there is still one play left on the table which I think is a high-probability play - at least in the short to immediate term.

What is that supposed to be? Well, look no further than the title of this commentary. Just as I wrote in our commentary "Rising Rates not a Given"; nearly ten weeks ago, arguing that the long bond definitely still has a lot of room to run (the yield of the 30-year Treasuries was at 4.84% the night our commentary was written), I think the long bond is currently a "sell"; as outlined in a post on our discussion forum last Friday morning with the yield at 4.24%.

It is to be said here that I hereby acknowledged all those analysts and economists who have gotten it wrong over the last few years predicting higher interest rates. 20 of the 22 primary dealers have previously predicted higher rates, with the chief economist of Bear Sterns, John Ryding, having the highest end-of-year prediction at 5.75% back in January of this year for the 10-year Treasury note. Since then, he has lowered his estimates, although it is still relatively high at 5%. Quote from the Bloomberg article: "Across Wall Street, bond-market prognosticators are finding themselves having to explain off-the-mark forecasts. The median estimate in a Jan. 3-7 Bloomberg News survey of 66 economists was for a 4.70 percent yield by July and 5.04 percent at year-end as the Federal Reserve raised its interest-rate target. Median estimates were also higher than the actual yield in 2004, 2003, 2002 and 2001, Bloomberg surveys show."; It is interesting to note that Stephen Roach, the bearish economist of Morgan Stanley, finally retracted his 3-year bearish views on the long board on May 31st - now starting that the 10-year Treasury yield may actually fall to 3.5% by the end of this year.

My sense is that a lot of these economists have capitulated. Sure, Bill Gross has always been open-minded and had called for lower yields for awhile now, but apart from him and Gary Shilling, I do not recall anyone else having made that call over the last few years and prior to last month. As Pete Richardson pointed out on our Discussion Forum, the Market Vane's Bullish Consensus on the long bond has been consistently giving us readings of 70% and over during the last week or so - which is a very overbought reading from a sentiment standpoint. I also want to point out another important development. In our commentary "Rising Rates not a Given"; nearly ten weeks ago, I stated: "The higher-than-expected CPI reading last week did not surprise us (although it did surprise quite a number of investors, apparently) considering the recent performance of the PPI - and considering the fact that some companies are now able to pass their costs onto their customers. In light of the CPI report, various publications are now calling for higher long-term interest rates - a call that has been very popular to make over the last few years (and a bet which one major Wall Street firm has lost a significant of money in)."; The bond bears were proven wrong. And since we got a pretty dismal jobs report last Friday morning, it is now perfectly natural to be bullish on bonds, but similar to the situation on March 27th, "it is never that easy."; In fact, I will argue otherwise. The fact that bond yields actually started rising in light of the dismal jobs report last Friday morning is a sign of at least a short-term or even intermediate-term reversal, as can be seen on the following candlestick chart from stockcharts.com:

30-Year US Treasury Bond Price (EOD)($USB) - Huge bearish reversal on the 30-year bond last Friday, not unlike the huge bullish reversal candle that we got in late March!

Of course, it is never that easy. Can money be made over the long-run just by reading charts alone? Probably not. Let's now throw in some analysis - you will find this initial analysis once again in our "Rising Rates not a Given"; commentary:

Monthly Holdings of U.S. Treasuries by Caribbean Banking Centers vs. the 30-year Treasury Yield (January 2004 to May 2005) - 1) The last time the holdings of U.S. Treasuries held by Caribbean Banking Centers experienced such a huge increase, the yield of the 30-year Treasuries dropped significantly over the next six months. 2) Sure enough, the yield on the 30-year Treasuries declined substantially since our 'lower rates prediction' on March 27th.

In that article, we mentioned that the last time the Caribbean Banking Centers (hedge funds, offshore banks, etc.) have increased the holdings of U.S. Treasuries, the yield of the 30-year Treasury bond has declined. At that time (during late March), we argued that the yield of the 30-year Treasuries should go down significantly in the next six months, and that "I would not be surprised if yields hit another 52-week low."; Since then, our "prediction"; has been proven correct, but what about going forward? Will rates continue their descent? Maybe, but I believe probability now calls for higher rates in at least the next month to a couple of months. First, the capitulation of all the major economists. Second, the huge reversal candle on the daily chart of the 30-year U.S. Treasury bond. Third, the huge bullish readings from the Market Vane's Bullish Consensus - which is very bearish from a contrarian standpoint. On reading the above chart, it is notable that the holdings of U.S. Treasuries by the Caribbean Banking Centers increased from $69.5 billion to $137.2 billion from December 2004 to March 2005 - almost a double and the highest amount of holdings we have seen ever. That was two months ago (end-of-month data isn't released until six to seven weeks later). Since then, the yield of the 30-year Treasuries have declined substantially from 4.84% to 4.28% - a move of 56 basis points lower despite another 25-basis point hike in the discount and the Fed Funds rate. My most educated guess is that this huge increase in U.S. Treasury holdings by the Caribbean Bank Centers was most likely some kind of "blow off"; phase - most likely the "flight to quality"; scenario which I have been discussing over the last six to nine months. That is, I think the likelihood of Caribbean Bank Centers increasing their U.S. Treasury holdings over the last two months is pretty slim, and given this scenario, I think we will see higher yields going forward within the next two months.

The "too bullish"; sentiment can also be witnessed in the Rydex US Government Bond Fund. Recall that total assets as of late March was at around the $75 million mark. At the time, I remarked that the fact that assets were this low in the Rydex US Government Bond Fund implies that investors were still very bearish on bonds - and thus bullish from a contrarian standpoint. Today, this number is at approximately the $150 to $175 million market. While I would not put too much weight on Rydex bond assets just now (since the history of this fund is only a few years old), it is interesting to note that the current level of assets is very similar to the level back in early February - the last time bond prices experienced a ST peak:

Rydex US Government Bond Fund (RYGBX) - The last time Rydex Govt bond was this high, the long bond made a significant top!

There you go, I am going to say it - I believe shorting the U.S. long bond is now a high probability play. That is not to say that holding the large cap growth/brand name stocks is now a sucker's play, but I just don't feel the risk/reward ratio is as good as what it was only a month ago. You know, I am a worrier at heart, and the action of the stock market (in particular the Dow Jones Industrials) over the last week or so is worrying me. Let's recap by looking at the chart of the Dow Industrials vs. the Dow Transports:

Daily Closes of the Dow Jones Industrials vs. the Dow Jones Transports
(January 1, 2003 to June 3, 2005) - 1) The Dow Industrials declined 81 points last week while the Dow Transports actually bucked the downtrend - rising a total of 6 points for the week.  The fact that the Dow Industrials hasn't had a more signficant rally since the April lows is getting me worried.  For now, however, I still think holding the major large caps and brand names is a very sound strategy (although I certainly would not initiate positions here).  Even with the latest rally in oil prices (despite a rising US$), I still do not think holding commodities is a sound strategy.

Even though the Dow Transports did not confirm the Dow Industrials on the downside last week, the fact that the Dow Industrials is underperforming given that the market was so oversold a month ago is worrying me. Under "normal circumstances,"; the Dow Industrials should be 250 points to 400 points higher. We are just not seeing that right now. In a secular bull market, I will probably ignore this, but per the Dow Theory, we are now in a secular bear market - along with the fact that our Global Diffusion Index is signaling a slowdown for the world economy just up ahead. Regular readers should know that I have been looking for another significant correction in the major indices sometime during late Summer and early Fall - could the correction between earlier than we have initially thought? We will definitely keep a close eye on the market this week to watch for any further signs of deterioration. For now, we will continue to hold but don't be surprised if we cut back on our 100% long position in our DJIA Timing System within the coming days.

Let's now take a quick look at our most popular sentiment indicators before we finish up this commentary. The AAII Bulls-Bears% Differential has gone up substantially during the last four weeks (now at 30%), but the four-week moving average is still relatively oversold at 14%. No warning signs as of yet from this indicator, although I will definitely be very worried if we move past 40% sometime in the next few weeks.

DJIA vs. Bulls-Bears% Differential in the AAII Survey
(January 2003 to Present) - 1) The Bulls-Bears% Differential in the AAII survey increased from 21% to 30% this week - shooting up 46 percentage points in a matter of four weeks.  On a four-week moving average basis (now at 14%), this reading is definitely still not overbought, although it is probably time to start trimming positions here.  The 'sell signal' does not come unless this reading increases over 40% in the next couple of weeks.

The Bulls-Bears% Differential in the Investors Intelligence Survey is slightly more oversold than the readings in the AAII survey at 22.8%. In fact, the 10-week moving average of this indicator is still very oversold at 18.76% - the lowest such reading since the May 14, 2003 reading of 16.98%. This survey (along with the AAII survey) is telling us to continue to hold on to our large cap growth/brand name positions, although like I have said before, they are not the high-probability plays they were just a month ago:

DJIA vs. Bulls-Bears% Differential in the Investors Intelligence Survey
(January 2003 to Present) - 1) The Bulls-Bears% Differential in the Investors Intelligence Survey increased slightly from 20.6% to  22.8% in the latest week - still in pretty oversold territory.  In fact, the 10-week moving average actually declined again from 19.06% to  18.76% - the lowest such reading since the May 14, 2003 reading of 16.98%.  Based on this reading, the bulls shouldn't be too worried until we see readings in the high 30s or even the low 40s. 2) Readings consistently over 30%!

Since I am a worrier, I can honestly say that the Market Vane's Bullish Consensus survey is still driving me nuts. I have mentioned this before: that the readings on the Market Vane's Bullish Consensus never really got that oversold during the many corrections we witnessed over the last 18 months. Moreover, the current reading of 67% is definitely on the high side. Oh well, you can never get what you want out of the market anyway. If the market tanks from here, the bears would point out that the Market Vane's Bullish Consensus survey "called it"; and that everyone should have seen it coming, etc. Hindsight is definitely 20-20:

DJIA vs. Market Vane's Bullish Consensus 
(January 2002 to Present) - The Market Vane's Bullish Consensus reading remained steady at 67% in the latest week - actually still in overbought territory.  Again, note that this indicator actually got very overbought (with a reading of 70%) in the early and middle part of November 2004, and yet the rally still continued.  We will be watching this indicator very closely in the weeks ahead.  What has continued to baffle me is that this indicator never really got that oversold (with a reading of 50% or lower) during the many corrections over the last 18 months or so.  To me, this is worrying.

Conclusion: Our position has somewhat changed. I believe long bonds are now a "sell"; if not a short (you can do so via the TLT - type in "TLT"; on Yahoo Finance and you will find it). That is the high-probability play I am envisioning for the next month or two. Otherwise, we will continue to overweight U.S. equities - specifically, the major brand names/large cap growth stocks - although I definitely would not initiate any long positions at this point in time. We will continue to avoid commodities, financials, and to a lesser extent, homebuilding stocks. Although the stocks that we recommended have, in general, outperformed - the dismal performance of the DJIA is worrying me. In a normal bull market rally, the DJIA should already be 250 to 400 points higher than where we are today. This is a worrying sign given the dismal readings we are getting from our Global Diffusion Index along with the fact that I still believe we are in a secular bear market (more on this next week). For now, I am still cautiously bullish but don't be surprised if we trim our position (to 50% or even 0%) in the DJIA Timing System in the coming days.

Signing off,


Henry To

Author: Henry To

Henry K. To, CFA

Henry To, CFA, is co-founder and partner of the economic advisory firm, MarketThoughts LLC, an advisor to the hedge fund Independence Partners, LP. Marketthoughts.com is a service provided by MarkertThoughts LLC, and provides a twice-a-week commentary designed to educate subscribers about the stock market and the economy beyond the headlines. This commentary usually involves focusing on the fundamentals and technicals of the current stock market, but may also include individual sector and stock analyses - as well as more general investing topics such as the Dow Theory, investing psychology, and financial history.

In January 2000, Henry To, CFA of MarketThoughts LLC alerted his friends and associates about the huge risks created by the historic speculative environment in both the domestic and the international stock markets. Through a series of correspondence and e-mails during January to early April 2000, he discussed his reasons and the implications of this historic mania, and suggested that the best solution was to sell all the technology stocks in ones portfolio. He also alerted his friends and associates about the possible ending of the bear market in gold later in 2000, and suggested that it was the best time to accumulate gold mining stocks with both the Philadelphia Gold and Silver Mining Index and the American Exchange Gold Bugs Index at a value of 40 (today, the value of those indices are at approximately 110 and 240, respectively).Readers who are interested in a 30-day trial of our commentaries can find out more information from our MarketThoughts subscription page.

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