Given that the economy has taken such a hammering lately, many have already feasted on the rebound in stocks. The rebound in treasury yields is more exciting if we play this right.
If we are serious about achieving success with investing, we need to always be comparing the desirability of various approaches. Investors and the investment industry as a whole do a terrible job of this, whether that be which stocks that they should be in or what proportion they should have of their money in a particular asset class like stocks or bonds.
We delve into this topic often in our other articles, and for this one, we will be looking at the relative merits of being in either stocks or bonds in general right now, to see what opportunities each may have for us as we leave the desolate island that we have chosen to strand ourselves on and set sail for home and see what sort of shape that is in when we return.
There are lots of folks who think that the right asset balance is a fixed one, choosing a certain allotment for each. We not only decide this in advance, we also adjust the holdings periodically to strive to keep this balance close to what we consider to be the right ratio.
There are several big problems with this approach, and all of them have to do with this having us invest blindly, almost like a blind trust. We might put half of our money in an index stock fund, with the other half in an index bond fund, and if one gets bigger than the other, we look to correct this imbalance.
The performance of these asset classes differs considerably though, and we often speak of the disparity in returns which bonds provide overall, and they greatly underperform stocks in the long run, which no one would even question. This does not mean that it’s always better to be in stocks, as there are times where bonds perform even better, during a bear market with stocks for example.
Investors who have chosen to do this blindly do not worry about matters such as how assets are performing or may be expected to perform, but given that our goal is about achieving performance, or we would think so anyway, it doesn’t make sense to choose between things to have our money in with no regard to performance.
When we take money out of something doing better and put it into something not doing as well, this hurts our performance, and we need a really good reason to do something like this, reason enough to sacrifice profits like this.
It turns out that, ironically, the reason people do this, ignoring performance, is because they have chosen ignoring performance as their sole strategy. You may put half of your money in bonds for instance because if your stocks go from overperforming to underperforming bonds, you have not allowed yourself to manage this change in performance so you are down to protecting yourself by diluting your risk and returns but giving up much more than you gain in the end.
The infected bear that had us in its big paws recently is a good example of this. A lot of investors chose to lower their returns for 10 years just for this moment, where they may have walked away from 100% better returns so they could save a few percent during this very infrequent episode.
This doesn’t even make sense even if you have chained yourself to your positions and thrown away the key, because stocks go up a lot more than they go down and go back up in time as well. There’s also always the option to pull the plug if things actually do get hairy, and amazingly, many investors are afraid to pull the plug but not afraid to hang on to it and get electrocuted.
While this sick bear was eating our lunch for a while, bonds were a much better place to be, and although we’re generally no fan of bonds, they do have their place and time and we told you that this was one of them. When stocks are starting to go down and may go down a lot more, when we see this big bear running toward us, being in anything else is a wise move. When bonds are instead going up, that can be a good place to hide for a while.
When the attack ends enough that the crowd is back at the picnic and not hiding in the woods, and we start to see stocks come back, and bonds flatten out quite a bit, it’s time to rejoin the party. Bonds have been our friend for a while, giving us shelter from the storm, there is going to be a time where the sun peeks out from the clouds and we want to go outside again and play.
It is not hard to know what to do during these times, but even just trying beats lying in the field and being trampled on by the stampede. We don’t even need to be thinking very much about this and this should even be fairly intuitive, provided we can clear our heads of all the clutter that always gets in the way of our thinking clearly about investing.
We’ve seen stocks rebound considerably, during what has been one of the best 5 weeks with stocks ever. We always want to be thinking of alternatives, and even looking toward the bonds that we just left in this strategy, even though bonds are extremely bearish right now.
This might not make any sense until you consider the fact that we aren’t just limited to playing the long side of bonds, and extremely bearish situations on the long side are extremely bullish on the short side.
We do need to always compare different things that we could have our money in, otherwise we’ll never know if we’re helping ourselves as much as we can, or even if we are hurting ourselves. If you do not look beyond your own yard, you won’t have anything to measure it with, and won’t even know that you could have a beautiful looking lawn right now instead of it being so unkempt and riddled with weeds.
We do not therefore just want to look at this opportunity that is coming up with bonds without also looking at where stocks are going, no matter how good the bond opportunity may be. It’s all about opportunity cost, whether with investing or in life, and we always need to be looking at different paths if we truly seek the best one or even a good one.
A lot of the fun of this rebound with stocks has already played out, where we have made a good amount back, and we’re facing some pretty big damage ahead of us, no matter how quickly we get back to normal.
Normal for stocks, back when the coronavirus was just a regional outbreak in China, wasn’t all that higher than we are at now. There may still be some room between where we are and may end up soon, a little upside left in other words, but this upside is certainly limited.
People may be looking well beyond 2020, and that’s understandable, but even these folks need to wonder about what we should do in 2020, and think about further out more when we approach it. We need to have our eyes on the future but not ignore the present. Not understanding this is a huge impediment to a great many investors, perhaps from fear of messing up, but almost always because they just don’t think of such things.
Leveraged Inverse Bond ETFs for Investors Seems Odd but Can Be Delightful
The last place these stock investors would be looking is leveraged inverse treasury ETFs, and to recognize such an opportunity, you really have to know something about bonds besides a way to settle for tiny returns over long periods of time, as people who buy this for income do.
This play is not about that sort of yield, but does involve it. We can bet on yield either going up by holding long bond ETFs, or bet on the yield going up by getting into inverse bond ETFs. Those who go long bet on it going down, even though they usually aren’t aware of this, and we can also bet the other way pretty easily with these short ETFs.
These inverse funds hold short positions in the asset, meaning that instead of buying them, they borrow someone else’s and sell them. The fund owes the bonds to the person they borrowed them from, and if their yield rises, meaning that their price has gone down, you get to buy them cheaper to pay them back and pocket the difference.
There really isn’t any fundamental difference between being long or short, as both are based upon a price that they are bought at and a price that they are sold at. In between is your exposure. Shorting just involves doing the exact same thing that going long does, only in reverse.
You are speculating that the price will go up when you buy them, or at least that’s what people should be doing if they were paying attention, and the people who buy them for the income certainly aren’t because they don’t even look at how price and yield may change. When you short them, you are speculating that their price will go down, and the two seek similar things and it’s only the direction that distinguishes them.
Stocks have a strong upward bias, going up more and more over time in the long run, but bonds have no such bias. Bonds have been in a long bull market of sorts, if we could call it that given It moves up over time like grass grows, but going against this trend is nothing like going against stock trends.
You can still of course make money shorting stocks, but you do need to carefully pick your spots unless we are in a long bear market, which this won’t be. Not really having a long-term trend like stocks do and instead being range bound removes the concerns about bucking the way something normally moves, as bonds are at home with either direction and do not go up over the long run, they go back and forth instead.
Bonds don’t move like stocks do though, so without ramping these positions up, they just won’t be as competitive, and only valuable when stocks are moving the wrong way. We can bring this up with a little leverage to make inverse bonds a contender even when both are moving up, if bonds are set to move up more.
While bond values are governed by price, we just don’t want to understand them just that way and looking at them in terms of yields does make the effect of yields more transparent, and allow us to more easily understand how they work and what to expect.
As bond prices have run up in value, yields have plummeted. You can measure changing bond prices with complete accuracy just by looking at changing yields. Changing yields also affect demand for bonds to a certain extent, and if we consider just now disenchanted a lot of income investors have become lately, this causes them to buy less and exert less upward pressure upon price and less downward pressure on yields.
Yields have been kept artificially low lately by the massive amount of treasuries that the Fed has been buying as they pull out all the stops to use monetary stimulus, and this cannot go on for all that longer. When they take their big boot off the market, it’s head will pop back up just from this, in our direction on the short side.
The fact that we’ve been pretty stable with yields under this intense pressure is very good news if you are considering going short because this is your side being under intense fire, and holding up this well shows the strength of the floor we are at, almost like cement
Yields are also conditioned by inflation, and while the relationship between inflation and bond prices is far looser than most think, inflation does move prices. People might be scrambling to get out of the bonds of other countries and into treasuries like a stampede, and traders may be falling over each other to ride this bull and make it run faster, but inflation will also speak at these events.
If inflation is expected to grow, for instance, then this is something that definitely will put yields up, because yields do matter to a great deal of bond investors. The traders will ride the wave in either direction, and cause the waves to be higher than otherwise, but investors also participate in the creation of these waves, the yield fans who actually will be hanging on to the bonds for this to matter.
Bond yields do have a floor, what people will take for lending their money out over time, and even though we have seen the bonds of some countries break through the floor into negative yields, U.S. treasuries are more robust, the most robust, and the pressure of the air at the depth we are at now is quite substantial.
We have seen this for ourselves with all of the downward pressure on yields from this crisis, and with stocks falling at record speed and much of the world thinking that the sky is falling and going into hiding, with our torching our economy in this panic, this is really what you call downward pressure on yields.
Yields holding up very well in the face of this intense pressure really shows us that we are at or very close to the bottom, and as we achieve more and more buoyancy as the situation improves, as we even make it back to the very low yields we had before this outbreak hit, there is likely to be more money to be made by playing this move than watching stocks eke out further gains and hoping that we don’t get struck down again while waiting for more.
There is Considerably More Upside and Less Risk with This than With Stocks Now
We need only consider where the ProShares UltraPro Short 20+ Treasury ETF was to start the year, $65.00, and where it is now, $28.60, to get a feel for how much we have dropped. Just getting half of this back means a return of 64%, with double that up for grabs if we get back to just where we were on January 2.
This ETF was worth about $118 in November of 2018, when the bond bull run really started to materialize, and this ETF is on the other side of the ball with this play. While may be too much to shoot for, the ceiling here is not just the level to start this year.
These things do not just shoot up like the stock market just has, but at certain times, they can move pretty fast as far as bonds go. This ETF had a gain of 70% over just 5 months in 2016, at a time where the yield of bonds dropped to record levels for a time and then rebounded.
We’ve set some much more impressive records with yields this time around, and have the additional stimulus of recovering into a very stimulated economy that will cause inflation to rise and perhaps considerably more than we have been accustomed to. This could blow the ceiling off of $100 if inflation goes up by a good amount and the Fed is reluctant to shoot it down due to the tornado that just struck us and will leave us more fragile for a while.
Raising rates too soon to combat inflation would be dangerous, with all that extra money borrowed lately on top of an already very high debt load and income to pay it back being reduced. We need to not put the price of this debt up at a time where we cannot really bear it.
If we are speculating on inflation going up, we need to be on the short side of bonds, and inflation shows no mercy to the long side when it rises. Not only does the interest you collect become marginalized, the value of your bonds goes down by a similar proportion.
While the long side gets bashed, the short side does the bashing, and it’s just so much better to be getting paid than doing the paying. The long side has gotten paid a lot over the last year and a half, and these things do shift back and forth quite a bit, and is about to take a big turn soon.
In addition to this, bonds are very oversold right now, and not a single person who has a clue about bonds could disagree. We’re in store for a good bounce regardless, and it doesn’t even take that big of a move to get a nice haul when leveraged three times.
This play is so solid that those who do not want to wait until a move up could do so with plenty of confidence, as we’ve settled in here and we’re bound to move up from here soon. Waiting for this move to form with not a lot of downside but all that upside might indeed cause someone to want to get their money on the table now.
We can actually take a pretty healthy sized leap with yields in just a single day, and keep in mind that we are tripling these differences with our leverage, so we might not want to miss out on too much of the fun that is set to happen.
Investors may even wish to use this as a hedge of sorts, adding some of this into their stock stew, and even those who are not very bold could benefit from helping their returns at least a little.
Only the bravest investors would even consider putting all of their money in a leveraged ETF, long or short. However, this would actually be very unwise, as stakes set this high require more skill to manage the risk, and there is always risk, and we don’t want an outlier to put a big hole in our ship and send us to the lifeboats.
Highly skilled traders could pull something like this off because, while this might lead to a gunfight, they are gunslingers and getting to become a good trader absolutely requires you to avoid being shot. Chances are, you won’t need your gun, but if you do, you better know how to use it.
A smaller portion, one that can be traded safely, is another matter though, especially with the fabulous risk-reward ratio of this play. You don’t want to be cranking things up so much that you can’t bail out the water if the ride gets too rough.
Thinking differently about bonds can open the door to some nice-looking plays indeed, and perhaps especially, this particular one that is in its initial stages of development now.
Sometimes the bears take over. They are actually a very nice sort provided we do not fear them and especially keep an open mind toward them rather than just hating. We need to choose to make friends with them instead of choosing to remain their prey and being so willing to become injured while trying to fight back. We do get to choose whose side we are on, and choosing the right side in a battle is key to winning.