Long Bonds Starting to be a Buy

By: Henry To | Thu, Jun 29, 2006
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What's New: For folks who are thinking of starting a hedge fund or who just want to be a successful long-tem investor, I would highly recommend reading Barton Biggs' latest work: "Hedge Hogging." It is also a very easy and entertaining read - even though the book does lack some structure. Please see our latest review of the book in our Favorite Books section. Finally, we would like to hear from our readers what your favorite books are. Please let us know by posting your personal choices in the "Favorite Books" section of our discussion forum.

Dear Subscribers,

July will be a crazy but exciting month for us - as my fiancé and I will be moving to Los Angeles in the middle of that month. There will be some flying as well as a road trip (with a stop at Vegas to see some family). Most likely, we will need to bring in a couple more of guest writers to fill my spots for the weekend of July 15th to 16th and July 23rd to 24th. I will attempt to send you some "ad hoc" emails in between - with probably an abbreviated mid-week commentary on the morning of July 20th. Don't worry - I will continue to monitor the markets while I am on my road trip as well as respond to emails while I am not driving. My new position (in my day job) will begin on July 31st, and I will take on new professional responsibilities, such as helping develop investment policy, set asset allocation, and select money managers for pension funds, foundations, and endowments. Again, subscribers who are in the West Coast should feel free to drop me a line should you wish to. Fund managers in the West Coast who are interested should also contact me - as we are currently seeking to expand our database of fund managers (which we use as a basis for our money manager selections for our clients). Finally: In last weekend's commentary, I stated that I will bring in a guest commentator for the weekend before July 4th - I am now retracting that statement since I have decided that I am going to write that one myself.

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") and our April 13, 2006 ("The Long Bond Secular Bull Market is Over") commentaries. 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:

30-Year T-Bond Yield ($TYX) - The 30-year Treasury yield is now trading near the top of its 18-month trading range. Is buying bonds a no-brainer here? This author would argue otherwise.

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. As our April 13th title suggests, this author believes that the yield of the 30-year long bond bottomed out (on an intraday basis) at 4.16% on June 13, 2003, but that does not mean that the yield of the long bond would just reverse and take off from current levels. 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:

30-Year T-Bond Yield ($TYX) - The 30-year Treasury yield took off two weeks after our March 12, 2006 commentary...

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:

Yield of Japanese 10-Year Government Bonds vs. 10-Year U.S. Treasuries (January 1999 to June 2006*) - 1) The Bank of Japan began its 'quantitative easing' program in March 2001. From a level of 1.27% in March 2001, the yield of the 10-year Japanese government bond started to decline in earnest until it bottomed at 0.53% in May 2003. The action of the 10-year U.S. Treasuries followed a very similar pattern - declining from 4.89% in March 2001 and finally bottoming at 3.33% in June 2003. 2) Differential between the 10-year JGB and the 10-year U.S. Treasury note is now the widest since June 2002!

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:

Rydex Bond Ratio - Rydex bond ratio bounced from its early-month lows - but it is still a significantly far away from its previous highs consistent with previous peaks (circled) of the yield of the long bond.

Treasury Bond - Net Commitments of Traders - Last week saw a bounce in the long position held by commercial traders - but it is still not as lopsided as it was in early May of this year. This author would like to see a higher long position taken by the commercials in the U.S. Treasury bond futures before going long as well.

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.

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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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