Bonds: Treasuries Sentiment Extremely Bullish

Don't Chase Best Performers

Treasury Bonds have experienced the strongest rally since 2008 Global Financial Crisis. It has been quite an impressive rally, which was already covered in last weeks Grid update (Article: The Grid: October Recovery). As we can see in the chart above, out of all the bond lasses, Treasuries have returned over 23% year to date. As a matter of fact, we can only really compare this type of panic bond buying to 2008.

Don't Chase Overbought Prices

The smartest thing any investor should do is follow the price of an asset. Common sense right? Well it seems common sense is not so common in the markets. You should never buy an asset when its too far away from its long term trend line, also known as the 200 day moving average. That just spells trouble as you chase bulls into a trap that eventually loses you money every time. The chart above shows us that when 30 Yr Long Bond prices get too far ahead of themselves, they tend to top and correct in a very abrupt and violent manner. Currently, Treasuries are at the second most overbought readings in at least two decades. In my opinion, this sets them up for a perfect short.

Don't Follow Dumb Money

Recent Merrill Lynch Fund Managers Survey from November 2011 showed hedge fund managers hold a relative high exposure to Bonds when compared to their decade mean. Consider that in February 2011 almost no one wanted to touch Treasury Bonds, while today the picture is completely different. I have to admit, hedge fund managers are not completely overweight this asset class like in late 2008, but nevertheless they are completely out of equities and commodities, and overexposed to cash and bonds.

The chart above is thanks to SentimenTrader website. The bond indicator above is a total sum of many sentiment tools from survey opinions, to speculators positioning, options positioning and money fund flows. It is quite obvious what the chart is saying - people are scared, expecting deflation and expecting a total economic collapse similar to that of 2008. I am not sure if things in Europe will get worse from here, where a certain country goes bust in coming weeks or months, however data is what I trust more than opinions and historically the data above tells us to stay away from Treasuries at present.

Don't Follow Economists

Consider the chart below - what we have is a ratio of price between S&P 500 and the Long Bond futures with a 200 day moving average, also known as a Stock Bond Total Return Ratio. At the same time I have overlapped the Citigroup Economic Surprise Index at the bottom of the chart with a neutral line. Rising price signals stocks are outperforming bonds and visa versa for the following price. Citigroup ESI above 0 signals that economy is beating economists expectations and visa versa.

What is interesting to note is how the economy has being doing better than economists expected it to. In other words, expectations of a recession became a consensus in recent months, but Developed World economy itself has not been that bad. So while the Citigroup ESI has now popped above the 0 line, the outperformance of bonds over stocks should already be in the process of ending. A smart fund manager should be buying risk on assets like equities and getting out of risk off assets like bonds. It sounds simple in theory, but hard to do while news constantly covers stories of pessimism.

Protect Yourself From Money Printing

People say they are waiting for Bernanke to announce QE3 before they buy something. That is fair enough, but I am pretty sure QE3 in stealth mode has already started anyway. Bernanke is king at lying to us all and he has proved it again. Every time a crisis occurs in our current economic system, authorities and central bankers have no proper solution but rather just flood the system with liquidity expanding money supply. What is interest to note is that over the last two decades, every time money supply and in particular M2 skyrocketed, Treasury Bond yields bottomed and started to rise. In other words, Treasury Bond prices topped and sold off. Currently, Bernanke is in there doing his magic again and I presume Treasury yields are about to reverse shortly...

Deflation Is Consensus

What is the main reasoning behind bond bulls purchases? They claim that the global economy is constantly suffering from deflation. Well, according to the Merrill Lynch Fund Managers Survey, for the second time since 2008, deflation seems to be the consensus outlook. What is interesting to note is that during both of those times, in late 2008 and middle 2010, as prevailing consensus frightened itself into a deflationary talk, Treasury Bonds sold off in a very very violent manner. I assume this time will not be different either.

Asset Allocations

The chart below is an asset class allocation statistics from the recent Merrill Lynch Fund Managers Survey. It shows the exposure managers have in their portfolios towards Cash, Equities, Bonds and Commodities on relative basis. The percentage readings are not as important as are the deviations from the decade's average.

So, imagine you were a fund managers and the Treasury Bonds rallied over 25% this year. What would you do when you see your industry peers - other fund managers - are holding high exposure of both Cash and Bond compared to its decade average? At the same time you also notice these same money managers, are currently underexposed to both stocks and commodities.

Summary

I'm not sure what you would do, but buying Treasury Bonds would be the last thing on my mind. Holding cash is where I am overweight right now, however in Australia we earn 6% interest on our high cash hoard. So therefore, personally, our fund is getting ready to allocate funds to commodities, which we believe are extremely oversold in recent weeks - especially Agriculture. At the same time, unlike Treasury Bonds, sentiment is very pessimistic. So therefore in summary, I'll keep it simple: short Treasuries, buy Commodities!