It's Gettin' Nasty

Thinly traded markets, as I've mentioned numerous times on this blog, are dangerous and prone to irrational swings over very short periods of time.  It's the kind of market environment that swallows up the uninitiated and confounds seasoned veterans.  The only way to successfully navigate this sort of climate, in my opinion, is to stay small and hide out in something like cash until the dust settles.  Though I I've dabbled a bit with equity over the last month, my combined positions outside of cash amount to a lowly 7% level of exposure.  Hardly the sort of portfolio that's looking for a meaningful pick up in share prices.  In fact, with the exception of my crude oil position (ticker: USO), I'll be adding to this cash position probably before the week is out.  My Dow Jones Transportation Average ETF (ticker: IYT) has hit my take out price and I'm simply waiting for an opportune time to square the position.  With equity gapping down at the open (the S&P 500's opening trade price was below yesterday's low trade, thus creating a 'gap' in the daily chart), it seemed foolish to sell into the hysteria, especially when this type of gap-lower open typically signals a bit of a relief rally the subsequent day.  To be sure, I'll be squaring my position if things move higher tomorrow.  It won't get me back to even, but it'll at least reduce the loss and the pain.

So with the S&P 500 down 15.49 (1.4%) on the day and 8 of the past 12 sessions, I think it's fair to say that equities are nearing an oversold condition and are ripe for at least a little bit of a bounce.  How far and how long could this bounce go?  It's hard to say at this point, but I would look to 1,080 and 1,131 on the S&Ps as the near term resistance points to trade against.  That said, the now obvious signs of a slowdown in the domestic economy coupled with rising sovereign debt concerns (Ireland just had its government bonds downgraded and Greece's bond yields have been quietly moving up to levels seen earlier this year) are going to provide a pretty gloomy backdrop for at least the next month.  Needless to say, this won't be too supportive of share prices.

However, the more interesting question, especially in light of the rising concerns over government debt, will be the effects on the U.S. Treasury market.  For nearly 100 years, U.S. government debt has been the world's only perceived 'risk free' asset.  Much of this faith had to do with the country's robust economic growth, relatively low debt levels, and strong regulatory environment.  As a result, Americans and our government have enjoyed a cost of debt capital that has been among the lowest in the world.  This cost tended, also, to drop even further during times of crisis as investors around the globe flocked to the perceived safety of Treasury bonds.  But with an economic slowdown at hand and steadily climbing federal deficits adding to our mountain of debt, I think it's at least prudent to ask ourselves the question of whether or not U.S. bonds are truly 'risk free' assets.  The honest answer, of course, is no.  In fact, in their book This Time Is Different: Eight Centuries of Financial Folly, authors Carmen Reinhart and Kenneth Rogoff clearly show how, in many ways, sovereign debt can more risky than that of a corporate or an individual.  More than anything, if you own the debt of a government, you simply own a promise to be paid back, nothing more.  At least a corporation or an individual can have assets against which you can make a claim in order to recover a portion of your investment.  Also, don't forget that the regulatory framework within which default claims are settled is a government administered process.  Can we really believe that a government, strapped for funds, would actually adhere to its own rules when trying to get out from under its obligations.  Of course not.  But while these ideas may seem extreme and somewhat paranoid, it's the fact that these ideas seem extreme and paranoid that increases the risk in our portfolios.  Too often it's the 'that can't happen' part of our portfolios that get us into the most trouble.

So with that little diatribe out of the way, I suppose you must waiting for me to begin trashing the U.S. Treasury market.  Well, unfortunately for you, I'm not going to do it.  What I will do, though, is point out that virtually no investor out there sees any real risk in owning Treasuries from the standpoint of default.  And in fairness, there's nothing, other than the increasing levels of debt and slowing GDP growth, to suggest that a default is imminent or even going to happen.  But with the financial condition of the U.S. government at one of its most tenuous points in history, I find it amazing that so many are willing to remain as confident in our country's debt securities as they are.  To an even greater extent, this is the case in Japan as well.  Japan is head and shoulders above the U.S. in terms of its debt load and yet, like the U.S., its government bonds are being bid up in a nearly insatiable manner.  Frankly this baffles me.  Had these securities been issued by a corporation in distress, I dare say we'd see the company's cost of borrowing move up rather than fall.  Somehow, though, these rules don't apply in the government bond world.

Sure, deflationary fears are partly to blame for this continued bid among Treasuries, but does this heightened fear warrant the dramatic drop in rates we've seen over the past month?  This, in truth, is my real issue with the Treasury market.  Rates have gone too far too fast.  It feels, to me, like investors are pushing all other assets aside and looking to Treasuries as the asset of last resort.  To an extent, this is to be expected.  But, as I outlined in my post entitled, What Yesterday Should Have Been, deflation has not yet taken hold and, therefore, going 'all in' on Treasuries isn't warranted as yet.  And even if deflation was occurring, I would have real concerns about adding significant exposure to the debt of a country whose cost of repayment would be rising (as a result of deflation).  Rather, investors should consider adding Treasury exposure on pullbacks rather than chase this runaway move.  Right or wrong, government debt will likely perform well over the short term if deflation persists.  Sooner or later, though, the speed of this drop in yields will cause Treasuries to fall precipitously.  The only question is when and how far.

As today's and yesterday's comments implied, I'm getting a little more negative on the near term prospects for the equity markets.  That said, I do believe that you have to continue watching the Treasury market for signs of what's to come.  With equities trading down fairly hard over the past week and Treasury yields falling sharply over that time, I think the prospects for a significant relief rally are growing.  This doesn't mean that the S&P 500 is likely to break out of its trading range, but I do think the prospects of a 30 point jump are quite real given the oversold conditions.  Especially if weakness in the Treasury market begins to materialize, look for equity to pop fast and hard.  If this does happen, though, I would use the move as an opportunity to shed equity positions and add a little Treasury exposure in preparation for what will likely be a challenging few months.  Cash, while certainly not sexy, will likely continue to be a good place to hide out.  Part of me looks at the run up in the Japanese Yen of late and wants to place a short position on the currency as a way of profiting from any capital flight or government intervention that may occur.  But, for now, this is simply an idea that needs additional consideration.  Until tomorrow.....