Today’s post is not going to be a popular one. I can sense it already. Instead of climbing aboard the “world is ending ala 2008” bandwagon, I will suggest an alternative non-consensus trade.
Yeah, yeah, I know - this moment reminds everyone of 2008.
Who doesn’t think;
- Central Banks are powerless to affect either markets or the economy
- fiscal policy stimulus is a complete non-starter
- stocks will plummet
- VIX will soar
- bonds will rally
- China is doomed
- the global economy will collapse
- inflation will sink into deflation
Given all this doom, it’s no wonder there is a record high for bond bullishness. Have a look at the chart of the Hulbert Bond Newsletter Sentiment Index and the accompanying commentary from author Mark Hulbert:
Contrarians in the bond market aren’t simply walking for the exits — they’re sprinting.
That’s because bond bullishness today is higher than it’s even been — or at least since the 1980s, when I began monitoring the investment-newsletter industry. To bet on higher bond prices today, you in effect have to bet that this overwhelming consensus will get it right. That’s just the opposite of what contrarian analysis teaches us is most likely.
Consider the average recommended bond-market-exposure level among a subset of short-term bond-market timers (as measured by the Hulbert Bond Newsletter Sentiment Index, or HBNSI). Earlier this week this average soared to 74.7%, a record at least since the mid-1980s, more than 30 years ago.
Not only is the HBNSI at an all-time high. Another source of contrarian concern is how quickly it has jumped. As recently as a month ago, for example, it was minus 11.8%. (See the chart at the top of this column.) In other words, there has been a veritable stampede to jump on the bullish bandwagon.
From a short term perspective, bonds have become the most crowded trade out there. And to be fair, they have been rallying consistently for the past few weeks. Yields on the 10 year US government treasury have fallen from 1.92% down to 1.70%.
My call for bond volatility to rise has been a complete dud. This flight into fixed income has dampened down vol to stupid cheap levels again.
It’s should be no surprise bond vol is sucking wind. Big investors like Bill Gross are leveraging up returns by shorting volatility. Here are some recent Bloomberg interview comments from the former bond king (whose new firm unfortunately desperately needs that first letter to always be in view - hat tip to the Grade 9 middle school investment class that sent in the picture):
IT IS NOT THAT COMPLICATED. IF YOU TAKE THE POSITION OF 1.5% ON THE 10 YEAR, WHICH IS SOMETHING I DO FOR THE NEXT 6-12 MONTHS, THEN, YOU REALIZE IS THAT THERE IS NOT MUCH OF A CAPITAL GAIN IN THE 10 YEAR. BUT, THERE CAN BE A SUBSTANTIAL YIELD. YOU CAN POSITION YOURSELF IN TERMS OF SELLING THAT RANGE. WE HAVE THE CALL IN OPTIONS GOING UP 6-7%. IT IS COMPLICATED. BUT, IT IS A KEY POSITION AND A KEY TENET FOR INVESTORS. WE SELL THE VOLATILITY AROUND IT.
Let’s get this straight. Bond investors have never been more bullish, large fund managers are picking up yield by shorting volatility, and we are bumping up against some significant overhead resistance in terms of price? This setup is screaming for a trade from the short side. Given the cheap volatility, I think a short position via long puts is a great risk reward in here.
I especially like shorting German bunds, but I believe all bond markets will decline in coming quarters.
In fact, I believe this trade also works well from a much longer time perspective as well. I recently stumbled upon financial author Mike Ashton’s web site. In a recent post he laid out the long term case against fixed income:
So what is the most crowded trade? In my mind, it has got to be the bet that inflation will remain low and stable for the foreseeable future.
This is a very crowded trade almost by default. If you want to be long momentum stocks and short value stocks, and no one else is doing it, then it can get crowded but this takes some time to happen. Other investors must elect to put on the factor risk the same way as you do.
But the inflation trade doesn’t work that way. When you are born, you are not born with equity risk. But you are born with inflation exposure. Virtually everyone has inflation risk naturally, unless they actively work to reduce their inflation exposure. So, from the day of your birth, you have a default bet on against inflation. If there is no inflation, you’ll do better than if there is inflation.
It’s a consequence of living in a nominal world. And the popularity of this bet at the moment is a consequence of having “won” that bet for more than three decades. Think for a minute. When you find someone who thinks that inflation is headed higher – and let’s cull from our sample all the nut-jobs who think hyperinflation is imminent – what is “higher” to them? When I tell people that our forecast is for 3% median inflation by year-end, they look at me like I’m from Mars, like three percent is so unfathomably exotic that they can’t imagine it. Because, for the most part, they can’t.
This month marks a full twenty years since the last time that year/year core inflation exceeded 3%. Sophomores in college right now have never seen 3% core inflation. (Median inflation has gotten somewhat higher, up to 3.34% in 2007, but hasn’t been higher than that since 1992). So truly, for many US investors 3% inflation is exotic, and 4% inflation is virtually hyperinflation as far as they are concerned.
So this is a very crowded trade.
Mike, I couldn’t agree more.
The 35 year bond bull market is over. I know that is a controversial idea, but I am sticking to it. It’s an awfully lonely call. I will leave it to everyone else to forecast a repeat of 2008, I am more worried about the crisis no one is expecting. Remember to buy your straw hats in winter…
Thanks for reading,