Thursday, October 14, 2010

Betting On Bubbles

Investors with huge amounts of assets under management (e.g. pension funds, sovereign wealth funds etc.) are buying US government debt at an astonishing rate. As a result, the annual return one can expect on a US 10-year Treasury is around 2.5%! Keeping in mind that the US central bank attempts to keep inflation between 1% and 3%, the level of this fairly long-term issue appears rather unsustainable. Consider the yield of this bond over the last several decades:

As a result, some are saying Treasuries are in a price bubble. If one believes economic growth will return to normal, Treasury yields are likely to increase substantially in the coming years. If, on the other hand, one believes that it's different this time, and that deflation will take hold over the long-term despite all the stimulus, then maybe these yields make sense or could fall even lower.

A few years ago, there was nothing the small investor could have done to participate in what he may perceive to be a yield anomaly such as this one. Treasuries are traded with amounts starting in the hundreds of millions or billions of dollars. With the proliferation of ETFs, however, retail investors are offered the opportunity to bet against what appears to be a bubble.

One such ETF has ticker PST and seeks to profit from rising treasury yields. For every daily 1% price drop in an index of 7 to 10-yr Treasuries, PST attempts to return a positive 2% to investors. Because of this daily rebalancing (which we first discussed with an inverse Gold ETF), the security's value is unlikely to go to zero, allowing investors the opportunity to absorb short-term volatility.

In return for this protection from complete capital erosion, however, the investor is giving up some potential gains. (e.g. if the security is down 2% one day, and then up 2% the next day, the price level will now be lower than where it started, as less capital was at risk during the 2nd day).

There are two commonly cited bubbles in today's markets: gold and treasuries. Incidentally, they seem to contradict each other in their predictions. The price of gold would suggest high inflation is on the way, while the price of treasuries would suggest deflation is a more serious threat. As a result, those who bet that both are bubbles may be hedged to some extent. If inflation does get out of control, treasury yields will go higher and PST is likely to benefit. If deflation occurs, shorting gold may turn out to be a winning bet.

While contrarian investors may find one or both of these bubble bets compelling, strict value investors may prefer to stick to investing in individual companies that are undervalued. The option belongs to the investor!

Disclosure: None


Unknown said...

Investors - please be careful when using these leveraged daily rebalanced funds!

For mathematical reasons, a bet on one of these is a bet against volatility.

For instance, if the underlying asset moves sharply one day, and then the next day reverses to close back at the starting price, then both a 2x long and a 2x short position will have lost value (due to the rebalancing).

For evidence of this, see the performance of SDS and SSO over the last few years.

Walter said...

Another way to play this is to buy puts on something like TLT. If you only want to hedge against hyperinflation, you can buy far out of the money puts. It will probably expire worthless but it's cheap insurance, at least probably cheaper than buying gold at the current time.