All signs point to a bubble in Treasury bonds

By John Jagerson and Wade Hansen. Editors, SlingShot Trader | Jun 13, 2013, 6:49 am EDT

Our recommended trade is a short position on the iShares 20+ Year Treasury Bond ETF (TLT ), which really isn’t representative of normal stocks. It’s not designed to rise in value indefinitely because it is a bond fund, not a profit-seeking corporation like IBM (IBM ), Apple (AAPL ) or Chevron (CVX ). The fund buys and holds U.S. Treasury bonds with a maturity of 20 years or longer. Those bonds have been doing very, very well since 2009 as investors bought long-term bonds as a store of value and the Fed accumulated more than a trillion dollars’ worth.

It is considered a little uncouth to suggest that Treasury bonds are in a bubble, but the symptoms of one are all there.  Consider the following list of commonly accepted symptoms of asset-bubbles and see if you agree that a bubble exists in bonds.

Buying Volume Reinforces Asset Prices:

Some trends are self-perpetuating merely because buyers keep motivating other buyers to enter the market. This has nothing to do with the fundamentals and is often triggered by a few very large investors. When you consider that the Federal Reserve has accumulated $1.9 trillion worth of Treasury bonds it shouldn’t be a big surprise that TLT has gone from average weekly volume of 5 million shares per week in 2007 to well over 50-million shares per week in 2013. The problem is that the bubble tends to burst when the big buyer decides to stop buying or just begins “tapering” purchases – sound familiar yet?

Bubble Assets are Inherently Unprofitable

The current yield to maturity (YTM) of the bonds held by TLT is 3.2% annualized. In other words, if you bought one of these bonds yourself then inflation would have to stay below an average of 3.2% for the next 20 years for those bonds to be profitable. How likely is that? Inflation isn’t over 3% yet, but it is not a stretch to assume that it will be eventually and when it gets there, these bonds would lock in an unprofitable return. Sounds a bit like the unprofitable dot-bombs of more than a decade ago. This means that investors who are still buying are relying solely on the bond’s utility as a store of value and prospects for future buyers.

Information  is Unevenly Distributed

This is sometimes referred to as asymmetric information because some investors have materially better information about the asset than everyone else. This is certainly true of the Federal Reserve (the largest market participant) but it is also likely true for the big banks who act as primary dealers in the Treasury bond market. As long as the status quo remains stable everything is fine, but when the “insiders” with better information make a change it tends to have very large ripple effects. This happened in 2007-2008 when several big investment banks and hedge funds started dumping mortgage backed securities that they knew were junk (having created those assets themselves) but the rest of the market didn’t.

News is Disproportionately Biased

With the exception of Bill Gross’ notorious bet against Treasuries in 2011, there are very few bears in the market. That is usually a bad sign that information isn’t being distributed efficiently and that investors are acting irrationally. While even we have said “don’t fight the Fed ,” we know that eventually an attitude of overconfidence leads to fragile bullishness and a subsequent crash as investors locking in profits accelerate a decline.

The bottom line in our opinion is that a bubble exists in bonds and if it pops, the risk/reward of such a trade is very attractive. If we are wrong, the downside is more limited because bond yields will have a more difficult time dropping below all-time lows established last year.

Even if we are right that a bubble exists in bonds, how do you time a new entry? Bubbles are infuriatingly long-lived and tend to break suddenly with minimal warning. However, from time to time major technical signals will appear just before prices pop, which could be the case for TLT now.

Technicals Point to a TLT Drop

Click to Enlarge Head and shoulders patterns frequently appear before asset prices drop. The decline in stocks in 2008, 2011 and early 2012 were all preceded by this pattern. Even the famous currency carry-trade (enjoying a small resurgence in 2013) collapsed in 2007 following a large head and shoulders pattern.

As you can see in the weekly chart, TLT broke the neckline of a head and shoulders pattern last week. The volume pattern was classic with a declining trend that began to rise on the break below the right-hand shoulder. Our initial projection is that TLT will drop an amount equal to the height of the pattern, which would put prices between $90-$95 per share by the end of the year. Bearish breakouts like this tend to experience the bulk of the move in the short term so we would expect prices to approach the final target by August.

Recommendation: Shorting stock is not for everyone, but if you are willing to take on some risk, this seems like an ideal entry opportunity to profit from a burst asset bubble. Short iShares 20+ Year Treasury Bond ETF on a break below $112 per share.

Option Alternative: Buy to open TLT August 113 Puts for $3.25 per share or less.

24/7 Trader has just launched the free Trader’s Talk forum! Join the trading community today.

InvestorPlace advisors John Jagerson and S. Wade Hansen are co-founders of LearningMarkets.com, as well as the co-editors of SlingShot Trader , a trading service designed to help you make options profits by trading the news.  Get in on the next trade and get 1 free month today by clicking here .