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Rationally Bearish on Bonds

May 9, 2011


Good morning. It was a very interesting week last week for investors, especially those who either trade commodities or have used security ETFs to gain exposure (chase returns) into the commodity area. The SPY was down 2.23 (1.6%) to close at 134.20, not a very significant amount given the recent rally, but the VIX, possibly seeing what can happen when sellers arrive and longs are forced out, was up a whopping 25% to close at 18.39. The hardest hit was the silver contract, which had the CME raise margin requirements for the fifth time in the last two weeks last Monday. That margin increase, combined possibly with an overbought situation already, helped the value of an ounce of silver (SLV ETF) drop by $14.40 (26.5%) on the week to close at 34.48. We actually had the June silver future top out at $49.53, almost right at the $49.50-50 target given by several of the technical people regularly heard on “Stocks and Jocks.” In addition, we had a double-digit move down in the price of crude oil, roughly from $114.83 to $95, before rallying back to $100 this morning. Even though any extensive rally causes a form of market amnesia among investors regarding what can happen when markets turn lower, this violent of a move in a short time is somewhat rare and definitely noteworthy.

Why does it concern me? It does for one very important reason; regular investors are seeing (we have discussed before) virtually zero returns on risk free investments. In other words putting your life savings in anything “almost” totally safe, like Fed paper or insured savings, is netting you virtually a big fat zero. That means, people being people and having planned on some income from savings, a greater propensity for normally conservative investors to get “caught” in something like silver or oil. Add to that the relentless drivel from supposed advisors (unregulated and seemingly with little regard for the investment facts) that were driving people towards gold coins, silver coins, etc. and you have the makings of some personal investment disasters. I will give a brief example of how that can work, especially in the Futures markets. On the security side of the investment business investors are forced to pay in full for any options purchased, or at least 50% of any stock purchases. In other words if you come to PTI Securities and want to buy 1,000 shares of a $100 stock you would have to deposit at least $50,000. As the stock appreciates (if it appreciates) your “buying power” does increase, but slowly. It would have to go to near $200 for you to finance a purchase of an additional 1,000 shares without putting up additional funds.

On the Futures side it is quite different. Instead of putting up cash for the stock, or some combination of cash and loan, you are required to make a “good faith” margin deposit that says you will cover all losses should they occur. So if you buy a Futures contract at, say, $100 you may be required to put up such a deposit of $2,500. If that particular contract were to move up to $103, not a real significant amount, your “equity” is now $5,500, the $2,500 you sent in plus the $3,000 you just made. You now have the “margin capability” since the “deposit” is $2,500 per contract to buy an additional contract, and so on as the Future advances. When it gets to $125 you (if you were inclined to go all out) could be long 9-10 Futures contracts for the original $2,500 investment (average price roughly $112). Now you have a week like last week and the market plummets back to your original price of $100, taking your 10 contracts with it. You now are down $120,000 ($12,000 per contract average price x ten contracts) and all you have ever deposited was the original $2,500. Ouch! You can also see how a surprise increase in the margin could also cause a problem, you were able to maintain 10 contracts at $2,500 per contract in this example, but if the margin number were increased to $5,000 you would have to sell 5 contracts (half your holding) just to make margin. That is, in essence, what happened last week.

The moral of the story is that it is natural to “look elsewhere” for returns when not much is available in your normal investment areas, but you must avoid the situation where someone is used to CD’s and somehow drops half his savings in gold or silver Futures contracts. The same is true in some commodity ETF’s that mimic the moves in the Futures. How do you make sure that does not happen? The same way you invest in securities at PTI, with smaller defined risk positions that will allow you to fight on another day if you are wrong or early. If you had tried to capture the expected move in SLV from $45 to $50 with a simple call spread, and the stock declined rapidly, you could very well have been ready (and able) to buy the $30-35 call spread on Friday afternoon. If you had bought either the Silver Future or the SLV outright at $47 (worse with margin loan) you probably would not have been able to be a buyer lower due to losses on the position already purchased. Again, it all comes down to investments that are appropriate in terms of product and size, and in managing risk, something we at PTI Securities can help you with.

So what about the market here? I am very concerned. Despite the very solid Employment Report on Friday (unexpected due to the recent Jobless Claims numbers) there have been some other indications of minor slowing. It appears that housing prices are still falling, another 3% in the first quarter, first quarter GDP was a disappointment, and the Employment Report showed no increase in wages paid (CEO salaries were up substantially last year). Add to that the Federal Reserve intention to stop QEII in June, meaning some percentage of the roughly $100B per month accommodation will cease, and the fact that both China andJapanseem to have less of an appetite forU.S.paper, and I am sort of smelling a minor storm of sorts for both the bond and stock markets. One thing that seems for sure is the “perceived” different view of the economy coming from the bond and stock markets. The recent rally in bonds would normally mean an expected slowing in the economy, while the strength in the stock market would indicate better times ahead, at least for the large companies. Can both happen? Normally most would say no, but maybe things have changed enough that we can have both a sputtering economy for most yet continuing pricing power and growing worldwide markets for others. I just do not trust the growth ofChinaandIndiato continue unabated if theU.S.falters, but maybe that is a biased opinion by someone that “hopes” it is not true. It is hard for me to believe that we do not matter anymore. I also really suspect that the smugness of our Federal reserve regarding their “independence” of making policy will prove to be a huge mistake. They could well be driven to change policy due to some or a combination of outside events, like some hot CPI number or a bad auction due to Chinese and Japanese either indifference, inability, or direct message. I really hope I am wrong here.

How to trade it? I really think the bonds are a sell here, and I am looking to find the right spot and product to make the trade. Last week showed me the rapidity that something might happen if a correction is on the horizon. For those discretionary clients we had some winners in Silver, Sprint, and Transocean, and for those in the SPY PIP (Protected Index Program) we had some winners there as well. In every case we had to be in before the move happened, both the moves in oil and silver were so rapid that I doubt very seriously if we could have seen the moves starting and been able to jump in. So if we want to play a direction, for instance be being bearish bonds over 124 (like both of our technical guests on “Stocks and Jocks have recommended), I think we have to do it carefully and with rational size in case there is another move up on the horizon. If we are right and it moves just as we suspect we will just have to be happy with a single. I also think that the stock market has been moving in the same direction (generally) as some speculative commodities, could a correction in the stocks be next?  Let’s be ready this week, it could be a good one. The market appears pensive, and we are ready to take advantage.

I cordially invite you to register for our complimentary In-Office Protected Index Program Seminar on Saturday, June 11th, 2011, from 9:00am – 12:00pm. My brother Dan and I will be presenting the strategies of the PIP that have resulted in returns for hedged client portfolios. This is an informative no-pressure session. Even modestly funded accounts benefit from this long-term money management program. We will have a nice contintental breakfast available for you. It is free but you MUST register to attend at  http://www.ptisecurities.com/Education.htm or by calling Sarah at PTI Securities toll free at 800.821.4968. I hope to see you there!