There are two ways to grow an economy. The West has borrowed a lot of money and consumed until kingdom come, while the East has saved and invested — which is the only sustainable way. This is why I am bearish on the West — the borrowing strategy backfires when you are finally tapped-out — and bullish on the East.
While most economic commentary is centered on the U.S. as the biggest Western market – and because most investors are U.S.-based and they would like guidance on how to avoid this mess – it’s worth noting that Britain and Japan are actually in far worse economic condition.
My outlook is that the only way to survive this economic unraveling for all investors in the West is to be active investors in BRIC and other organically-growing emerging markets.
Record Profits but No Jobs – What Gives?
A lot has been said of late about the record amount of corporate profits that U.S. corporations have been reporting, but where is the record amount of jobs? They say just around the corner…
Those profits are because of record cost-cutting — there are your missing jobs — and record (government) borrowing. You cannot possibly expect that profits can keep growing by cutting ever more workers and borrowing ever larger amounts? But, this is exactly what has been going on.
It is not Bernanke’s fault that we are in the current economic mess — it’s Greenspan’s. Greenspan’s monetary policies to the U.S. economy were the equivalent of feeding excessive amount of sugary foods to a healthy person. At close to 400% of GDP and climbing, the total indebtedness in the U.S. economy after 25 years of this monetary madness is similar to layers of fat on an obese person. But what does Bernanke do to fix his predecessor’s problem? He feeds the economy even more sugary foods by way of zero interest rates and quantitative easing.
A diabetic likes sugar, but is sugar good for such an individual? Such an individual needs to buy a pair of sneakers and run every morning, rather than eat more cheesecake — and this is exactly the perennially missing structural reform in Western economies.
This is why an accomplished endocrinologist, like my dear friend Dr. Vladimir Bakalov at the National Institute of Health, would do a much better job as Fed Chairman than Dr. Bernanke. He has more than 20 years of primary research in the field of endocrinology and is well-qualified to teach in any Ivy League institution. I am highly confident that he grasps the effects of money-printing better than a monetary economist.
Two-Year Note Yields at New Lows
From Dr. Bakalov I know that if insulin can be avoided with diet and exercise, it is always the better option. This constant fidgeting between insulin (hiking interest rates) and ever-increasing glucose regiments (zero fed funds and QE) is not going to end well — it is not working out at the moment.
And the two-year Treasury note yield made yet another all-time low last Friday at .5461% on news of lower-than-expected GDP data, in spite of all this “cheesecake” stimulus on both the fiscal and monetary side.
I continue to believe that in the present environment, high-yield bonds should be avoided. The economic data has been coming in on the weak side for almost two months and the weaker U.S. GDP numbers on Friday are just the latest confirmation. It makes no sense for the iShares iBoxx Corporate High-Yield Bond ETF (NYSE: HYG) to be trading where it is trading, while it makes all the sense in the world for the Vanguard Extended Duration ETF (NYSE: EDV) to be doing well.
A straight-out long position in the EDV fund is advisable here as 10-year Treasury note yields are flirting with taking out the 2.88% low yield for 2010. As a reminder, the 10-year note yield made it all the way to 2.08% in December 2008. We have certainly been operating on super glucose monetary stimulus since we saw 2.08%, but I wonder how the bullish crowd would explain the 10-year Treasury note yields breaking 2.50% this summer (hint: this is exactly what I think it will happen).
On the options front, I like September and December $100 TLT calls (further out expirations carry less risk) for an aggressive trade. And I would keep 20% of any BRIC portfolio in U.S. zero-coupon bonds as represented in the EDV. Luckily, the HYG ETF trades options too. It appears that someone is shorting the September $85 HYG calls in size. There were 74 contracts in open interest, before this 1000 contract trade went through near the bid price at $3.60 on Friday ($3.50/$3.90). This is an educated guess — I have no guarantees.
Shorting calls is not the same as buying puts as theoretically it exposes you to unlimited losses, but in this case the theory is not applicable. This is because the HYG ETF is comprised of overpriced junk bonds that have already rallied a lot and they are highly unlikely to zoom higher with this weakening economic data. Plus, unlike with stocks where a company might be taken over and send the stock soaring, thus making the short calls strategy disastrous, there is no company to take over a junk bond ETF. So, shorting the September $85 HYG calls works marvelously in this case. Plus, the premium decay (a.k.a. “theta bleed”) works in your favor with a short options position.
However, investors who cannot short calls — the strategy requires a higher level of options clearance and more advanced risk-management skills — can look into in-the-money September or December strike puts — like $90 for example — which should benefit from a sell-off in junk bonds, which is coming, in my opinion.
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