TRADING THE WORLD
by Pearce Financial, LLC
December 11, 2008
Based on trading activity and reports, the following markets are setting up for potential trading opportunities.
This year is shaping up to be a great year for both James Bond and the Treasury bond. While 007 took in a record-grossing opening amount for a Bond film, investors sent the bond market sky-rocketing to new record highs. During this time, investors have behaved much like this secret agent’s favorite cocktail: Stock investors shaken, bond investors not stirred.
The Treasury bond market has definitely been the place to be as of late. Looking for security? Got it. Treasury bonds are backed by the US Treasury. They’ve never defaulted on ‘em. Government paper is very liquid and is considered ‘risk free’ by many. Looking for an investment that can actually increase in value while the stock market tanks? Got it. Traditionally, Treasury bonds usually rally when the stock market declines as investors make a flight-to-quality. Gold couldn’t even keep its head above water this year. Treasuries were the one market that did not get pulled down into the financial abyss as a liquidity crisis spread across the financial markets around the globe. Looking for sizable capital gains? Got it. Just because you looked at a price quote on Bloomberg and saw that the yield of the 30-year Treasury bond was 3.06% does not mean investors in US Treasuries are getting the same returns that your grandma is getting on her one year bank CDs! No, far from it. You can realize capital gains on Treasuries. Looking at the bond yield alone is like looking exclusively at the dividend paid on a stock and assuming that’s the return being paid to stock investors. The 30-year Treasury bond gained 5.4% just for the month of November alone (the biggest monthly gain since 1981) and it has gained almost 28% for the year (the most since 1995). Those are some mighty returns for just a boring ol’ bond market! ‘M’ would most definitely approve.
Fundamentally, the 30-year Treasury bonds were already benefiting from flight-to-quality buying as stock markets worldwide plunged week after week, month after month. Central Banks around the world have been drastically slashing interest rates in record sizes. Just this week, the Bank of England cut another 100 basis-points off of their rate (their rate now stands at the lowest level since 1951), the ECB lowered the benchmark lending rate by a record 75 basis points to 2.5%, Sweden’s Riksbank almost cut rates in half when they lowered the key rate by 175 basis-points to 2.00%, and even New Zealand cut a record 150 basis-points. It’s almost a foregone conclusion that the Fed will drop rates again when they meet in a couple of weeks.
Another supporting factor for the US Treasury bond market is that Fed Chairman Ben Bernanke recently announced that the central bank is considering purchasing Treasuries to help the economy. Since the Fed Funds Rate is already at 1.00% and is expected to be reduced to at least half of that at the December 16th FOMC meeting, the Fed is about out of bullets in that gun. But they still have another weapon they can use: providing liquidity to the market. If the Fed buys Treasuries, it can create a ‘domino effect’ as mortgage rates decline, homeowners refinance, and mortgage investors buy Treasuries to hedge against the declining rates. This creates almost insatiable demand for Treasuries and sends them even higher.
Bulls, Bears, and Bubbles
After such a rosy introduction, we are now going to blindside you with our position on the Treasury bond market: We believe that the 30-year Treasury bond market has entered the final stages of establishing a major top. If this is merely a peak in an overall bull market, it can present a major selling opportunity. However, if this top turns out to be the end of the multi-decade long bull market, this may shape up to be a once-in-a-lifetime selling opportunity!
From a purely technical perspective, the US Treasury bond market has been in a major bull market since establishing a major low way back in 1981. Within the context of this multi-decade bull market, there have been several major tops established where the Treasuries peaked and then sold off precipitously for several months. At the previous major highs, the bond market accelerated its ascent and went into a nearly parabolic move to the upside. When this occurred, the bull market turned into a bubble. Like all bubbles, they eventually burst and erased a significant amount of the bull market gains. It took just a fraction of the amount time to erase those gains as it did to create them. At best, it looks as though the market is merely repeating history by establishing one of those major tops. This would still suggest that the US Treasuries are going into a bear market for the next several months. At worst, the possibility exists that this could be the end of the multi-decade long bull market. However, we will eat this elephant one bite at a time. The market needs to change the behavior pattern that has existed for nearly three decades before we declare that the bull market in Treasury bonds is dead. For now, we will just concentrate on the near-term expectation of a major trend reversal.
Fundamentally, nobody seems to be thinking a step ahead of the crowd here. The markets typically factor the crowd’s expectations into the price. By the time the expectations are realized, the market may have everything already factored in. What happens if Paulson accomplishes his goal to push home loan rates down to 4.5%, the Fed reduces rates to less than one percent, and the Fed purchases more than half a trillion dollars in agency and mortgage securities of government-sponsored enterprises such as Fannie Mae? Well, then what? Most likely, we see a spurt of economic activity and a ‘relief rally’ in the US economy. If the price of US Treasury bonds have been bid up into the stratosphere they have a long, long way to drop in the event that some of the positions start getting hit with liquidation orders. A decline in Treasuries probably will not manifest in a nice, orderly fashion, either. Since such a huge influx of capital was used to purchase bonds and more and more buyers entered the market on the way up, just a small amount of selling could spread like wildfire and quickly turn into mass liquidation as everyone heads for the exits at the same time. This is probably why there is a saying that, ‘the market goes up on an escalator, but it does down on an elevator’.
A History of Bond Price Behavior
Looking at the price charts, we can see that the 30-year Treasury bond market has exhibited a pattern of moving from Major Swing Lows to Major Swing Highs for at least twenty-seven years on the long-term price charts. Each of the Major Swing Lows has been higher than the previous one and each of the Major Swing Highs have been higher than the previous one as well. This price pattern has been remarkably consistent, both in terms of price and time. This consistency is what has led us to believe that bonds may be right on the cusp of embarking on a multi-month decline. Traders/investors need to prepare themselves.
Let's examine what this market has been doing since the first Major Swing Low in this channel was made in 1981:
First, the macro-view. T-bonds established Major Swing Highs (lows in yield) in April of 1986, September of 1993, October of 1998, and June of 2003. After hitting Major Swing Highs the 30- year Treasury bond market declined and established Major Swing Lows (highs in yield) in September of 1981, October of 1987, November of 1994, January of 2000, and May of 2004. So far each Major Swing High (low in yield) has been higher than the previous Major Swing High and – 3 – December 7, 2008 each Major Swing Low (high in yield) has been higher than the previous Major Swing Low. Thus, the pattern of higher highs and higher lows defines this market as being in an up trend on the long term charts. In September, T-bonds exceeded the 2003 Major Swing High of 124-12 and the market is currently at a new, all-time high today. This obviously qualifies as a new Major Swing High. This pattern helped us identify the 2003 top, it helped us peg the 2004 low, and it helped us call the 2006 buying low. At the 2006 low, we had the audacity to predict that T-bonds would then embark on a journey to new all-time highs over the next several months. It took a bit longer than we expected, but it finally arrived!
The time intervals between the Major Swing Highs have been seven years and six months, five years and two months, and four years and nine months. The current duration of and five years and seven months (June of 2003 to December of 2008) since the last Major Swing High fits in nicely with the other historical occurrences.
The price intervals between the Major Swing Highs have been thirteen points and 31/32nds, ten points and 24/32nds, and twelve points and 5/32nds. That’s an average of roughly twelve and a quarter points. T-bonds have currently reached a new, all-time high of 135-16.5. This exceeds the previous Major Swing High by over eleven points. This matches the minimum expected price high, based on history. We would have to witness a price of roughly 136-24 on the 30-year Treasury bond to match the average price advance beyond the previous Major Swing High. Still, the market does not have to stop there. The bond market could continue its stellar run. We are just merely observing the similarities of what it has done before and watching to see if the same pattern will repeat again.
We are not trying to catch the exact top of the market. After losing a fortune when the South Sea Company bubble burst, Sir Isaac Newton said, “I can calculate the motion of heavenly bodies, but not the madness of people”. We concur. Predicting the exact high or low for a market is too difficult, if not downright impossible, especially if the market in question enters bubble-type conditions. Fortunately for all of us, picking a top or bottom of a market is not required to be successful in the markets. Knowing the trend of the market is the important thing. Therefore, our objective is to identify a trend change as early as possible and then look to establish positions on the short side of Treasuries. Price patterns are not always exact so traders need to be flexible in regard to their entry/exit approach. Traders also need to exercise sound risk management by taking small, calculated risks on each trade. You should never, ever have all of your equity at risk on any trade/investment idea. And don’t add to a losing position by trying to ‘dollar cost average down’. You only have to be wrong one time with that kind of strategy to lose everything!
During the big declines that took place between these four Major Swing Highs and Major Swing Lows, the time durations of the declines lasted eighteen months, fourteen months, fifteen months, and eleven months respectively. As far as size goes, the four declines retraced approximately 58%, 57%, 71%, and 60% of the rallies that had taken place between the previous Major Swing Lows (highs in yield) and the most recent Major Swing Highs (lows in yield). History suggests that, at a minimum, the next big decline in bonds could last for at least a year and the market should retrace more than half of all the gains that it made between the 2004 Major Swing Low of 103-02 and current Major Swing High (currently at 135-16.5). This implies that 2009 will be a year for the bond bears to reign supreme. If this scenario plays out again, there should be plenty of meat on that bone to fatten one’s trading account.
How can we be sure of our forecast? Well, one can never have a guarantee of what the future might hold. However, a consistent price behavior pattern that has been in place for decades just might give a speculator the probabilities needed to justify taking action. But we have been around long enough to know that the market could make variations in this behavior pattern as well. Mark – 4 – December 7, 2008
Twain once said, "History doesn't repeat itself, but it does rhyme". These are words that we as traders/investors (both are really speculators!) would do well to remember in our involvement with the markets. The smart trader will initiate a trade based on favorable probabilities, but he constructs his risk management plan based on possibilities. There is a very important difference between the two. (For more discussion on this subject, request our ‘white paper’ on risk management). You must devise an exit plan (protective stops, options, hedges, etc.) in the event that the market deviates from the blueprint. Employing proper money management and managing your risk consistently is the only way to survive the markets. Never bet the farm on a trade no matter how good it looks or how compelling the case is.
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