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Whenever the topic of inflation arises, the two words that most often come from investors’ mouths are “gold” and “silver.” And while it’s true that gold and silver are inflation hedges that offer large potential returns, they also tend to carry an equally large degree of risk.
Common wisdom holds that the prices of commodities will keep up with inflation and help investors by delivering high potential returns even as consumer prices rise. There’s just one problem with that. Volatility. Risk is measured by volatility. Huge losses that occur when you need the money can be disastrous, as many investors learned in the two recent bear markets.
Another basic principle of economics is that the interest rate on a bond is like rent paid by the bond issuer to use the investor’s money for a time. Academic research has shown that bonds deliver an average return of 3.7% a year more than inflation. The total return is equal to this rent income plus an inflation premium. Right now, with long-term rates at record lows, investors aren’t getting any inflation premium.
Because interest rates include that inflation premium, interest rates and inflation usually move in the same direction. If inflation rises, then interest rates will have to go up. While investors in gold and other inflation hedges are trying to protect against inflation, one of the only ways you are virtually guaranteed to be on the right side of the inflation bet is to own interest rates.
As an exchange-traded fund (ETF), ProShares UltraShort Lehman 20+ Year Treasury (NYSE: TBT) makes it possible for you to do this. This ETF is designed to go up in value when the interest rates on long-term Treasury bonds go up. It uses derivative contracts that take leveraged positions in these bonds. Fund managers buy $2 worth of contracts for each dollar invested, giving investors leverage and a little more bang for their investment buck.
Bond prices move down as interest rates move up, and this ETF allows you to profit from a decline in the price of bonds. Again, it uses derivative contracts, but by using Treasuries, almost all of the credit risk is eliminated. The U.S. government has never defaulted on its debt, and investors in Treasuries continue to assume a default will never actually happen.
The potential upside for TBT is impressive. Right now, the Federal Reserve is buying most of the available U.S. bonds. Since the financial crisis began in 2008, the Fed has purchased almost 70% of all Treasury bonds issued, and they now own even more than China. When its program of buying these bonds, known as “QE2,” ends, most likely later this year, prices are likely to fall and TBT could bounce as much as 25% higher to about $40. This projection is based on the security’s chart pattern, with $40 representing the first level of resistance (see the chart below).
Long-term, in the next year or so, could see TBT double as interest rates go back to more normal, pre-crisis levels — especially if inflation rises above 3%. This would put TBT at the level where it traded before the financial crisis, when economic conditions were considered normal.
TBT’s price is near its all-time low. It is also oversold on a technical basis, meaning we should expect a move higher. Stocks can remain oversold for extended periods of time, however, they almost always follow the fundamental trend. Value investors use oversold extremes to establish long-term positions, confident that they will be rewarded in time. With the fundamental trend likely to favor higher inflation, TBT represents a value play on that idea.
The chart above shows the Rate of Change (ROC) indicator in the bottom of the frame is about two standard deviations below normal. The ROC indicator is like a car’s speedometer for the stock price, showing how fast the price is moving. Just like cars moving too fast or too slow in traffic tend to cause problems, stocks moving up or down too fast also tend to encounter problems.
To help spot what’s too fast or too slow, I’ve added Bollinger bands to the ROC indicator. These bands apply standard deviations to the indicator, a term that’s used to define what’s “normal” from a mathematical perspective. They are often used by technicians on price charts, but applying them to an indicator like ROC provides insight into when a “buy” or “sell” should be made. When the ROC moves outside of the bands, the general trend of the stock price usually changes direction. So in TBT’s case, we see that ROC fell below the lower Band. What’s important to notice is how the black line in the bottom (rate of change) tends to bounce between the two blue Bollinger Bands. From the bottom, where it is now, I expect the rate of change to increase along with the price.
Action to Take–> The risk for this investment is limited. A more detailed review of the chart shows there is support at $31, and I would not expect TBT to fall below that level. This price level is where the double bottom can be seen forming last August and September. These are usually reliable bottom patterns, and prices should remain above those lows. If inflation picks up to as much as 3%, then we can easily expect the long-term interest rate to rise to about 6%. From current levels, that would lead TBT to roughly double in the value.
If you’re worried about inflation, consider TBT. As a leveraged ETF investment that goes up along with interest rates, I think it’s a better bet than gold, silver or other commodities as a hedge against inflation. Consider placing a stop-loss order at $31, limiting risk to less than 10%. When QE2 ends, you could very well see a quick 25% gain and possibly even a 100% gain in the next 12-18 months.
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