Wednesday, June 24, 2009

A contrarian looks at the bond market

Back on December 1, 2008 I turned long term bearish on bond prices after being a bull for 27 years! (Remember that when bond prices go up interest rates go down, and when bond prices go down interest rates go up). I regard this call as a quintessential example of the contrarian approach to markets that is explained in my book. Here's why.

The first ingredient of any contrarian analysis is historical value investigation. Where is the market relative to previous highs and lows it has seen in previous years? We have to remember that bullish market crowds are associated with overvalued markets - prices have risen too high. And bearish market crowds are associated with undervalued markets - prices have fallen too low. So if you think you see a bullish or bearish crowd developing you have to check your observations against the position of the market relative to its historical extremes. All of this is explained in chapter 6 of my book.

Now take a look at the first chart above this post. It is a weekly chart showing about 30 months of yield information for the 10 year US treasury note. Back in 1946 long term treasury yields dropped to a historical low of about 2.00%. This should be compared with the all time high in the 10 year yield which was 15.96% in September of 1981. So on December 1 of 2008 it was pretty clear that at a yield of about 3.00% the 10 year note was a lot closer to its historically low yield than to its highest yield. Moreover, it had just broken below its previous low yield point of 3.07%, action that was sure to strengthen bullish opinions. For these reasons alone it made sense to be on the look out for a bullish investment crowd in the bond market (bullish in the sense that it expected prices to go up and yields to drop).

There was a second important element in my historical analysis. As I had pointed out in my long term bond market forecast that I had made in 1982 (see the scan in the post I cited earlier) the cycle of falling yields that started in 1981 was expected to last 30 years, plus or minus a few.
By late 2008 this cycle of falling yields was already 27 years old and getting long in the tooth.

These considerations made me certain that a good contrarian trade was at hand - provided a well developed bullish bond market crowd could be identified.

In late November of 2008 people all over the world were fearful of an emerging depression. The S&P 500 had made a temporary low at 740 on November 21. Flight to quality was the preferred investment mode - people dumped stocks and corporate and mortgage bonds and bought government securities. Buying treasury notes was also a deflation play, one that would pay off big time if deflation set in, a typical accompaniment to depression.

So I thought then that the bullish bond market crowd was strong - it was the mirror image of the bearish stock market crowd. And on this basis I thought it made sense to sell out any treasury security postions I held and move those assest back to cash and to the stock market. This I did.

I thought at the time that yields would drop a little more - I cited the 2.50% level in my December 1 post. As you can see from the chart at the top of this post the 10 year yield eventually dropped as low as 2.04% a few weeks later, but has since risen as high as 4.01%. And I think it will go higher still.

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