Warning Bells, Are You Listening?

August 23rd, 2012
in contributors

Article of the Week from Investing Daily

by Bruce Vanderveen, Contributing Editor,  Investing Daily

There is an old aphorism on Wall Street: no one rings a bell to signal a market top or bottom.

bellsSMALLIt’s late August and the markets are relatively calm. European leaders have issued reassuring statements, US economic indicators have improved and even consumer sentiment is more positive.  These combined factors are kindling among investors a spirit of cautious optimism—a big change from just a few weeks ago.

Yet, under the surface placidity, the warning bells are ringing.

Follow up:

When US voters go to the polls in November, they will be voting for leaders of a country which is $16 trillion in debt, is spending nearly 50 percent more than it takes in, and has 46 million people on food stamps. Even worse, the US faces up to $150 trillion in future unfunded liabilities, chief among them Medicare and Social Security.

What does this stark reality mean for investors? They should prepare for rough times ahead.

Not surprisingly, massive sums have been moving out of stocks and into bonds. However, bond investors must never forget that when interest rates rise, bond prices fall. Conversely, when interest rates fall bond prices rise. With interest rates near record lows, the greatest price risk is now to the downside.

Bond rates are poised to rise, hurting investors in long-term securities as bond prices, true to their inverse relationship with rates, fall.

Let’s look at a bond-oriented strategy to protect your portfolio.

US Treasuries

Vast, deep, liquid, and global, the $16 trillion US treasury market is the realm of central banks, sovereign nations, and large asset pools all over the world. Major holders of securities however, are in the US itself, and include the US Federal Reserve, the Social Security and Medicare trust funds, pension funds, and others. China and Japan lead foreign holders with each over a trillion in Treasuries.

With their perceived safety, US Treasuries are the benchmark for all other bonds. If Treasuries fall, all others follow.

One might expect, with the high US debt, Treasuries would be rated worse than junk bonds. This is not the case, because the Federal Reserve is in charge of the printing press for the world’s reserve currency and Fed Chairman Ben Bernanke has repeatedly stated he will do anything to avoid deflation (i.e., print money).

How long can the Fed keep interest rates low as debt increases rapidly? Those who think the end may be near can short the Treasury market with ProShares Short 20+ Year Treasury ETF (NYSE: TBF) or ProShares UltraShort 20+ Year Treasury ETF (NYSE: TBT).

A note of caution: Timing is uncertain and TBT, as a leveraged exchange-traded fund, loses potency over time due to daily rebalancing. It is a short-term (a few weeks at most) investment. I would stay away from TBT unless some kind of panic starts. TBT is more a speculation than investment or hedge.

Municipal Bonds

Banking analyst Meredith Whitney caused a stir in late 2010, by predicting large-scale municipal defaults in 2011. It didn’t happen. However, this year three California cities have already declared bankruptcy and Moody’s warns more are coming.

You can short municipal bonds with Market Vectors Short Municipal Index ETF (NYSE: SMB). It is interesting to note that SMB is the only inverse interest ETF up on the year.

High-Yield Bonds

In the past, high-yield bonds have been a harbinger of economic downturns. It makes sense. Weaker companies, which issue the high-yield paper, are more likely to default in hard times. You can short high-yield bonds with ProShares Short High Yield ETF (NYSE: SJB).

Parking Money

On Monday, July 23, the US 10-year Treasury note reached an all-time high as its rate fell to a record low of 1.4 percent. Investors should realize that the reason for this is not a love of Treasuries. Rather, it was fear of default in the euro zone.

Large sums of (central bank created) money from huge global money pools fled out of risk investments to the relative safety of Treasuries. When you manage tens of billions of dollars or more, there is nowhere else to go when default threatens. No other market can absorb the huge amounts. It’s more a parking of money than investing.

This, along with the Federal Reserve’s printing press, explains the mystery of why a heavily indebted country such as the US has such low interest rates.

Despite an upswing in the last few weeks, bond rates are still near record lows and they may go lower if, as seems likely, the euro crisis erupts again. Yet, from this juncture rates can go up much further than down.

Storm warnings are manifest. The storm isn’t here yet, but it is time to start preparations.

What do you think of this article? Please post your feedback in the “comments” section below!

Bruce Vanderveen is a Florida-based financial writer and investor.

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