FORECASTS & TRENDS E-LETTER

by Gary D. Halbert

August 3, 2010

IN THIS ISSUE:

1.  The Erratic Course of Treasury Bonds

2.  The Next Lost Decade?

3.  How to Capitalize on Rising and Falling Yields

4.  Attend Our Free Long-Term T-Bond Webinar

Introduction

Should you invest in long-term US Treasury bonds now?  Its a good question since many investors are flocking into these and other bonds in a big way, and have been ever since the financial crisis in 2008.  According to data from the Investment Company Institute, mutual fund investors have continued to pour tens of billions of dollars per month into taxable bond funds, much of it in Treasury bond funds.  With interest rates at or near all-time lows, it would seem that bond prices would have to fall in the future, making long-term Treasury bonds a very risky bet right now.

However, long-term Treasury bonds have a tendency to confound even the most knowledgeable experts.  A little over a year ago, I wrote about how long-term Treasury bonds had outperformed stocks over the last 30 to 40 years, a fact that surprises many investors.  In that E-Letter . I cited studies that turned Wall Streets conventional wisdom on its ear by showing how Treasury bonds, the safest investment around when held to maturity, had actually outperformed stocks over an extended period of time.

The experts tell us that Treasury bonds arent supposed to outperform stocks over long periods of time but, for the most part, they have.  Perhaps the status of US Treasury securities as one of the safest (if not THE safest) investments, especially during times of global turmoil, explains why Treasury bonds have been so popular in recent years, thus confounding the experts. 

In this weeks E-Letter, Im going to discuss the outlook for Treasury bonds for both the short-term and long-term future.  Well cover the impact of geopolitical influences, a struggling economic recovery, and the possible effects of continued deficit spending by the US government.  We might find that wed consider ourselves lucky if bonds struggle for only a decade and not much longer.

Finally, Ill guide you to a way to invest in long-term Treasury bonds that has the potential for gains no matter which way bond yields go in the future.  In fact, were having an online seminar featuring this innovative investment program this coming Thursday, August 5th at 1:00 PM Eastern Time (10:00 AM Pacific).  Someone is going to have the potential to make a lot of money when interest rates turn higher, and it might as well be you.  Click on the link below to register for this free, no-obligation learning experience:

The Erratic Course of Treasury Bonds

Looking back over the last few years, long-term Treasury bonds have had quite a ride as measured by the Barclays Capital Long-Term Treasury Bond Index .  After posting a gain of over 9% in 2007, just as the subprime crisis was beginning to unfold, long-term Treasuries returned over 24% in 2008 as the credit markets seized up.  In 2008, the long-term Treasury bond asset class was virtually the only one to post a gain that year as investors sold everything and sought the safety that only US Treasuries can provide.

In 2009, long-term Treasury bonds pulled back, losing almost 13% as investors realized that the global economy wasnt going to melt down and they gradually regained an appetite for risk assets such as stocks and stock mutual funds.  Early in 2010, the experts decided that the good times in bonds were over.  In a Bloomberg Radio interview in March, bond guru Bill Gross stated that Treasury bonds had seen their best days .  

Yet, long-term Treasury bonds had the highest return of any asset class during the first half of 2010, despite experts predictions to the contrary.  Many cite the sovereign debt crisis experienced by the PIIGS (Portugal, Italy, Ireland, Greece and Spain) as the source of global uncertainty that prompted another flight to quality.  And looking forward, we see no shortage of potential crises that might prompt yet another shift to Treasury bonds, driving yields down and prices up.

A recent Financial Times article noted that Royal Bank of Scotland analysts had announced a significant downward revision to their US Treasury bond yield forecast, predicting that the yield on 10-year Treasury notes could fall as low as 2.75% during the 4Q of 2010, down from a prediction of 4.4% at the beginning of the year.  If accurate, this could mean further downward pressure on bond yields, moving prices upwards.

Since long-term Treasury bonds are also sensitive to inflation expectations, the rate of economic recovery could also affect bond prices in the short-term.  Last weeks announcement of only 2.4% GDP growth in the 2Q could actually help to feed an expectation of disinflation (or even full-blown deflation), which could also be good for long-term Treasury bond prices in the short term.

While the above factors may create upward trends in bond prices in the short term, its the long-term view that we need to be concerned about.  Todays historically low interest rates have to go up at some point, for a host of reasons.   What will happen if foreign buyers of our Treasury debt suddenly demand higher interest?  What if one or more of the major ratings firms lowers the US Treasury bond rating?  What if inflation rears its ugly head due to out of control spending and trillion-dollar deficits?

Millions of investors who have herded into bonds over the last two years will get hammered when interest rates begin to trend higher, and they will at some point.

A Lost Decade in Bonds?

You may recall many articles, including in this E-Letter, about the lost decade in stocks.  This term refers to a 10-year period during 2000-2009 in which stocks had a negative return.  While most of the articles came out at the end of the first full decade of the new millennium, a review of recent data indicates that the phenomenon in stocks is still going on.  As of the end of June 2010, the rolling 10-year annualized return for the S&P 500 Index is a loss of 1.59%.

In light of historically low interest rates, some analysts are now predicting that bonds, and especially long-term Treasury bonds, may be in for a lost decade of their own.  After a significant multi-decade run of favorable returns, I guess its not unreasonable to assume that the situation could reverse. 

Dont get me wrong, Im not trying to talk down US Treasury bonds.  Its just that much of the attractiveness of these bonds to global investors has been that the US is less troubled than some of the other developed economies across the globe.  Being the least bad in a gathering of global economies may make you the best choice as a safe harbor, but it doesnt mean that your economy is suddenly healthy.

With interest rates at or near historic lows, there seems to be nowhere for them to go but up.  Sure, we might see some periodic spikes in bond prices due to global uncertainty, but its important to remember that interest rates are the true determinant of bond prices.  When interest rates eventually begin to rise, and they will, the situation in bonds wont be pretty.

If we are, indeed, in store for a lost decade in bonds, then the money flowing into bond mutual funds from retail investors may be setting these people up for another big disappointment.  In the good old days, we used to think of bonds as less risky and volatile than stocks.  However, in an environment of rising interest rates and possible inflation, long-term Treasury bonds could be just as risky as stocks, if not more so.

Unfortunately, many of these retail investors are looking in the rear-view mirror when making their investment decisions.  The last 10 years have been good for bonds, while stocks have continued to suffer.  Using this backwards-looking approach, investors are obviously choosing the asset class that did best over the last decade without thinking about what might happen in the years to come.

How to Capitalize on Rising and Falling Yields

I think its pretty clear from the above discussion that the experts have no idea which way bonds will move in the near term.  While continued out-of-control deficit spending will almost certainly create upward pressure on yields eventually, no one knows exactly when this might happen.  I dont have a crystal ball to tell you how long-term Treasury bonds will continue to perform well, but I can tell you about an investment strategy that has the potential to make money no matter which way Treasury bond yields go in the future.

Since our AdvisorLink Program began in 1995, we had searched for a strategy that actively manages US Treasury bonds, and especially those with long-term maturities.  However, it wasnt until 2007 that we met the principals of Hg Capital Advisors and were introduced to their Long/Short Government Bond (LSGB) strategy.  Byron Haven, Ted Lundgren and Dennis Shaw teamed up to create this active management strategy that seeks to capitalize on both rising and falling yield trends. 

Since we have previously introduced the Hg Capital Long/Short Government Bond (LSGB) program in the past, Im not going to repeat much of the background information.  However, in light of the various forces affecting trends in long-term Treasury bond yields right now, I think that our more aggressive readers may want to consider allocating a portion of their risk capital to this program now. One big reason is performance . 

Hg Capitals LSGB program has delivered an average annualized return of over 16% this year as of June 30.  The LSGB program also posted a whopping gain of 60.4% in 2009 as interest rates went back up temporarily.  These are actual returns in real accounts, including my own account, net of all fees and expenses.  As always, past performance is no guarantee of future success.

Compare Hgs returns to the Barclays LT Treasury Index that posted a 12.93% loss in 2009, which illustrates the value of having a strategy that can short the Treasury bond market. Of course, Hg Capitals LSGB program is not without risk, having posted a worst drawdown of -25% during the worst of the credit crisis in 2008. 

Ill discuss performance in more detail below, but lets first talk about Hgs proprietary strategy.

The Long/Short Government Bond Trading Model

Hg Capitals bond trading model is a 100% mechanical, quantitative approach based on actual observations of market activity.  From these observations, Hgs portfolio managers have identified a number of what they call rules and have incorporated them into the LSGB strategy.  It is important to note that these rules are actual observations of historical market activity, as opposed to conceptual ideas of how it might work or should have worked.  Hg also stresses that their rules are not developed by optimizing or curve fitting to historical data, since optimized models often fail to produce favorable ongoing results.

Each day, Hg Capital enters current market data into their computer system, and their software analyzes the various bond yield rules in order to determine which single rule is the most likely, from a statistical standpoint, to be indicative of the markets action during the next trading day.  As you might imagine, the computing power necessary to run this analysis is extensive.

The trading model can produce one of three alternative signals: 1) invest on the long side of the long-term Treasury market; 2) short the Treasury market using a specialized inverse mutual fund; or 3) go to a cash position (money market fund).  All positions use 100% of the account and there are never any partial or staged positions.  The LSGB Program uses specialized mutual funds sponsored by the Rydex family of mutual funds that provide a long and short exposure to Treasury bond price fluctuations.  The long side also has a moderate 1.2X leverage, but there is no leverage available in the short (inverse) fund.

The primary emphasis of the LSGB model is to identify the position with the highest probability of gain during the next days market action.  If there is no clear trend, the strategy remains in the Rydex US Government Money Market Fund.  The strategy does not attempt to predict what the market may do over the next week, month or year.  All it is concerned with is the next days market action.  If the model is long 20 days in a row, this means that it got 20 independent signals on 20 consecutive trading days that all said the program should be long. 

The Hg trading model is 100% mechanical, and Hg will not override a signal, even in the case of a national emergency.  Hg has, however, modified the model as necessary to adapt to changing market conditions.  For example, when we first offered the LSGB program, it did not have a way to go to cash and was always either long or short.  In 2008, this proved to be problematic, so Hgs principals went to work and developed a way for the strategy to be neutral using a money market fund.

Hgs own statistical analysis indicates that their systems have been right approximately 60% of the time, based on daily historical data.  Our month-end performance analysis shows the bond program has had a positive monthly return approximately 67% of the time, but remember that past performance cant guarantee future results.

Hgs methodology does not employ any formal stop-loss techniques.  However, since no signal lasts for more than one trading day, the effect of a bad trade may be limited by its short duration.  Hg is quick to point out that the Long/Short Government Bond Program is aggressive, and should not be seen as an option for investors who want are looking for a traditional buy-and-hold Treasury bond exposure. 

Performance Evaluation

The detailed performance information linked below shows that the LSGB Program compares very well to equity and bond benchmarks, both on an inception-to-date and year-to-date basis.  The LSGB Program is also virtually non-correlated to the broad stock and bond markets, as well as to the other investment programs offered by Halbert Wealth Management, as I will discuss in more detail later on.

Since its inception in December of 2004, the Hg Capital Advisors Long/Short Government Bond Program has posted an annualized return of 16.77% as of the end of June, net of all fees and expenses.  The worst-ever drawdown (peak to valley losing period) was 25.01%, which occurred during the recent subprime meltdown at a time when the model did not allow for a move to a neutral position in the money market.

Click on the link below to see the actual performance history and analytical data for more comparisons along with detailed monthly returns.  Past performance does not guarantee future success.  Also be sure to read additional important disclosures at the end of this E-Letter.

Correlation is the Key

As I have previously noted, the Hg Capital LSGB Program seeks capital gains from frequent trading of long bond index mutual funds based on the movement of interest rates.  With that being the case, you may be wondering why you should consider this program, since it is so much like actively managed equity investments.  After all, if the Advisor is managing the asset for capital gains, what does it matter whether its a stock or bond?

Thats a very good question.  The answer is that the potential for capital gains in bonds, both long and short, generally occur independently from those of equity investments.  As a result, successful trading activities can produce a return that has little or no correlation with both equity and bond indexes.  By correlation, I mean the tendency of an investment to go up or down in relation to other investments.

Non-correlated investments are often preferred because they have the potential for gain without respect to how any other investment in the portfolio may perform.

The chart below will illustrate this concept.  It shows the extent to which Hg Capitals LSGB Programs performance is correlated to major stock and Treasury bond market indexes.  A value of 0.700 to 1.000 is indicative of a high correlation, values between 0.400 and 0.700 indicate a moderate correlation, and values below 0.400 indicate little or no correlation.