“The Next Great Investment Bubble is about to Explode”

By Travis Johnson, Stock Gumshoe, January 28, 2009

Ian Cooper’s Options Trading Pit newsletter is out with a new ad, in a letter from Brian Hicks, that tells us that the biggest investment bubble is about to explode … and that Ian’s got the trades to tell you about that will help you profit from this explosion.

They don’t hide the “bubble” they’re talking about — that’s not the tease today — they just tease us that they’ll share the best trade to profit from this bubble’s burst, but only after you subscribe to this options trading service (it’ll cost you a “discounted” $799, FYI).

So what is the bubble? It’s the bubble in US Treasury Bonds, as you might have guessed. There was a short time, during the heat of the panic, when short term treasury debt even traded with a negative yield, meaning that at least one person was willing, albeit briefly, to pay the US government to hold his money for him.

For those who are unfamiliar with bonds, we’re talking here just about the sovereign debt of the United States — the bonds issued by the Treasury Department. They are sold in many different loan periods (3 month bills, 10 year bonds, etc.), and are considered by most people to be the only truly risk-free investment (at least, free of risk of default), because they are backed by the tax-collecting ability of the United States. Interest rates are extremely low right now, which is quite handy because the government is going to have to borrow a lot more money to help finance bailouts and keep the government running as tax receipts dip in this recession.

There are a few main reasons (in my opinion) why many folks believe that US government bonds will see this bubble burst as they fall in value (which would mean that interest rates are going up — the bond’s price moves opposite the interest rate).

First is that foreign governments will stop buying these bonds — a growing percentage of treasuries are in foreign hands right now, particularly in the hands of large exporters like Japan and China. If they stop buying (or worse, start selling), because they have less money now, too, the demand will drop and prices will have to drop (meaning yields go up) to bring in more demand. Of course, if they do this and bring prices down then their massive portfolios of these bonds lose value, too.

Second is that supply is increasing dramatically with the expectation of trillion dollar deficits this year and in the near future. And if supply increases without an increase in demand, again, the price will have to drop to bring in more demand.

And third is that the inflation picture might change dramatically in the near future. While we’re currently experiencing some “disinflation” and the Federal Reserve is fighting the prospect of deflation, the inflation hawks and gold bugs believe that the Fed’s attempt to increase the money supply will lead to inflation, and possibly to hyperinflation. Bonds are great investments in deflationary times, but they are awful to own if inflation takes off (except, arguably, for inflation-adjusted bonds).

The ads say that “This next bubble isn’t just going to pop… it’s going to explode,” using as examples some previous bubbles (real estate and internet stocks). Maybe so.

Here’s a little hint of the hyperbole for you:

“Ian – the man who called the sub-prime collapse back in February 2007 – has just issued his latest – and MOST URGENT – warning:

“‘The U.S. Treasury bubble–very soon–is going to burst wide open.’

“And as the Treasury bubble explodes, Ian and his small but wildly successful group of investors will be getting rich… by effectively shorting the U.S. Government… taking lightning-fast profits on the order of 86%… 138%… 140%… and 220%.

“Here’s how it’s going down:

“As you know, Ben Bernanke, Henry Paulson and the boys at the Fed and Treasury are flooding the financial system with cash. They’re slashing interest rates… and they’re bailing out seemingly every big corporation that raises a hand.

“It’s almost as if Bernanke and Paulson are openly begging for inflation.”

So that’s part of the argument — the ad also goes on to say that the next big leg down for the economy will begin in April, 2009, and that this will allow for a second opportunity to profit from these strategies. That time period argument is based on the schedule for mortgage resets, with apparently a large number of them scheduled to reset, particularly option ARMs, starting in that month. While it’s anyone’s guess how federal policy on foreclosures might impact this, and the problem has probably mutated somewhat with the new policies we’ve already seen and with the already strong wave of foreclosures, the date is real, and folks have been looking at this date as the start of a new foreclosure wave for some time. There’s a good article from BusinessWeek about it from last Summer, if you’d like more detail.

Of course, the bubble in Treasuries is an oft-discussed topic in the financial press — you’ll see any pundit worth his pinstripes talking about the bubble in T-bills, or at least suggesting that they should be avoided and that the only reason anyone holds US government bonds right now is because of a “flight to safety.” Ian may well be right on this, and his newsletter may provide useful advice otherwise, but it’s certainly not an idea or a concept that you require an investment newsletter to comprehend.

One of the best articles about this came out in Barron’s a few weeks ago — on January 3, a day before Ian apparently issued this advice to his subscribers. The Barron’s article is here (I think non-subscribers should still be able to access that link, sorry if I’m wrong) if you’d like a good overview of the situation, which hasn’t changed all that dramatically in the weeks since (the article is dated Monday, January 5, but Barron’s actually comes out on Saturday morning on the weekend preceding the publication date, Ian’s advice came out, so his ad says, on Sunday).

As Barron’s says, and as most pundits seem to agree, it’s quite difficult for an ordinary investor to “short” Treasury bonds, (that is, to borrow them, sell them now, and hope to buy them back at a cheaper price to repay your loan in the future, as you can easily, though at some risk, do with most individual stocks). With the advent of Exchange Traded Funds for a few debt indexes, however, you can bet against US government debt using put options or short ETFs.

I’m neither an options specialist nor a bond trader, so I don’t know what the best or safest way to trade this idea of a “bursting bubble” in Treasuries would be, but here are a couple examples:

The main short ETFs that can be used to bet against these bonds are the UltraShort 7-10 year Treasury (PST) and the UltraShort 20+ year Treasury (TBT). Each aims to return 2X the opposite daily return of its respective index (the Barclays Capital indices, which many people still refer to as the Lehman bond indices). It’s worth being cautious with these UltraShort ETFs, even if you like the idea of leveraging a bet against these bonds — many UltraShort ETFs have done a reasonable job at hitting their target on a daily basis, but over time the leverage impact has made them perform wildly differently than their underlying index on a long term basis, some of these short ETFs have even lost money in the long term when their indices have fallen, the opposite of the result that you’d expect. Here’s a pretty good article about the unexpected results that some longer-term holders of these ETFs would have seen last year.

Perhaps a cleaner and more predictable way to make this bet, though it might cost a bit more, is by buying puts against an ETF that tracks these bond indices. This is also likely to be closer to what Cooper recommends, since it’s an options trading service. You can go to iShares to see all the government bond index ETFs they provide for various time periods (they also have other fixed income ETFs for other sectors, like agency bonds, etc.).

Most of these ETFs have options available, so you can simply choose a date in the future when you think they will have fallen further (the farther out you go, the higher premium you’ll pay) and buy a put option that gives you the right to sell that ETF before the expiration date at a set price. If the ETF falls faster than other options traders are expecting, the premium might rise so you can sell it back for more money … or if the ETF actually falls below the strike price you bought (by more than the amount you paid for the option) then you should almost certainly be able to make a profit by selling or exercising the option (people almost never exercise options, which would mean in this case that you buy the ETF at a lower price and sell it to the other party in your options transaction at your agreed-upon higher price).

You can also, if you’re trying to really leverage your bet, buy call options (the right to buy at a price, instead of sell at a price as with puts) on one of the UltraShort ETFs. This is something that’s often best left to day traders and cowboys, but if you’re right and trade nimbly this would offer the highest potential returns (and the greatest potential to lose your investment, of course). Since Cooper is promising fast and high returns, it’s quite possible that this is one of the possible recommendations he’ll be making.

I know probably many of you out there in Gumshoe Land have done similar trades, or used similar tools, so please feel free to flesh in these ideas with a comment below.

I’d agree that the likelihood of Treasury bonds being this expensive in the years to come seems very slim, but I have no idea when the “flight to safety” might end … and though I also expect we’ll see inflation return, I can’t discount the possibility that we’ll see possibly an extended period of deflation first … but really, to tell the truth, I have no idea what’s going to happen with these bonds that trade based on so much more than simple inflation expectations. Buyer beware, and make sure to become well informed if you decide to pursue any of these strategies.

Happy investing, all!

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22 Comments on "“The Next Great Investment Bubble is about to Explode”"

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Rose Smith
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Rose Smith
January 28, 2009 1:26 pm

The Ultra Short ETF’s mentioned above…the ones that return 2X the opposite daily return of its respective index and which can behave in wild and unpredictable ways in the longterm…how long is long term? Is long term 3weeks, 6months, 1year?

Also, options trading. How long has this been a popular method of investment? Since the collapse? or have savvy investors been doing it for awhile?

Sorry to start the comment string with questions instead of insights.

EYOUNG
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EYOUNG
January 28, 2009 1:32 pm
Maybe I’m innocent and naive, Gumshoe, and I’ll admit that, as well as being woefully ignorant, in many ways in this insane world of mortgage finance,,, BUT, that said, wouldn’t it be better to make $.25 in interest, than to go for the full $1.00 on these ARM resets, and LOSE that even partial interest??? Seems to me, these companies are cutting off their noses to spite their faces, metaphorically speaking. Yes, I know there is a whole lot of shenanigans been done when the mortgages were taken out,,, but it does seem to me that a lot of this… Read more »
sequential
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sequential
January 28, 2009 1:33 pm

Ian Copper has a pretty good track record for 08 for this service options trading pit.
S

Elissa Stein
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Elissa Stein
January 28, 2009 1:47 pm
Actually, Travis, some of the options don’t work as well as the actual etf’s themselves. .An example comparing QQQ to QID and options is as follows: as the Q’s dipped from Jan 6th to Jan 20th, they moved from $31.28 to $27.96 or $3.32. If one had in the money puts with a delta of -.80, the puts would have gained approximately $2.65. During that time period, the QID moved from $51.49 to $63.12 for a gain of $11.63. Some of the options are thinly traded on these ETF’s. This is just one example for that specific time period. Hope… Read more »
dgd
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dgd
January 28, 2009 2:12 pm

The question with the bursting bubble is always WHEN? Options thrive on volatility. A slow flattening of the bonds is anathema. So… will govt. policies exacerbate or mitigate volatility? And does this much foreknowledge in the market matter? It certainly didn’t seem to with other bubbles.

dgd
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dgd
January 28, 2009 2:20 pm

I have been fretting about the thin option trading on these ETFs. Hardly seems worth it for the play. Perhaps the Ultrashort funds are the way to go.

SageNot
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SageNot
January 28, 2009 3:16 pm

More than a few years ago we had those Zero Coupon Bonds in 5yr increments, are they still ’round or do they now go under some other ID?

For sure this Treasury bubble will burst one day, but if the Fed keeps it’s present stance for any lengthly period, the option time premiums will eat you up. Long dated Leaps w/b best, but talk about their illiquidity argues against this method.

theaccusersgift
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theaccusersgift
January 28, 2009 8:57 pm

Be careful.

As one analyst talking about timing the “Treasury Bubble” observed, there was a “Treasury Bubble” in Japanese government bonds for over 20 years.

Shorting a long ETF/going long a short ETF might NOT lead to “instant profits”.

Buyer beware.

harry
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harry
January 28, 2009 9:59 pm

the best and easiest way to short the bonds is by shorting the bond futures on the chicago board of trade,but you have to be very carefull the leverage there is very high,you can short 100,000 worth of bonds by putting up $4500 margin.
as an example had you shorted the 30yr bonds 4 weeks ago when the hit 141.00 at todays price of 129.00 your $4500 would be worth $16500

jagor
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jagor
January 29, 2009 5:02 am
You seem to have totally forgotten TIP’s–Treasury Inflation-indexed securities. As Steven Goldberg wrote recently on Kipplinger.com, “Inflation-protected bonds offer almost all of the advantages — and almost none of the disadvantages — of regular Treasury securities.” http://www.kiplinger.com/columns/value/archive/2009/va0127.htm The way I put it is that TIP’s are the only investment where, “heads I win; tails I don’t lose.” The best way to get in on this is by buying VIPSX. Oh, you don’t believe we’re in for inflation? Well, how many of you remember when it cost three cents to mail a first-class letter? That’s what it cost up do 1958.… Read more »
Gravity Switch
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January 29, 2009 7:43 am
Good point, many folks, including Bill Gross, are buying TIPS these days. Keep in mind that the interest rate is still extraordinarily low, though I would agree that they’re probably a safer bet than regular treasuries in this environment. However, if interest rates climb substantially for a reason other than CPI inflation, and if CPI inflation is not higher, TIPS will drop in price just as regular government bonds do, though since they haven’t gotten “bubbled” to the same degree the impact would certainly be less. I would expect TIPs to benefit from higher inflation, but not necessarily from the… Read more »
danny m
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danny m
January 29, 2009 7:50 am
I realize that there may be some money to be made in the short term as people speculate on what T bonds will do, but unless I miss my guess it will be a long time before you would make any real money long term on these trades. If, as the fed has suggested, it becomes a buyer of T bonds would this not mean that the interest rates would be able to remain low? Yes, the fed would become the only buyer of them and they would just print the money to do so, but in theory could they… Read more »
Shawn
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Shawn
January 29, 2009 8:11 am

An alternative way to play treasuries is don’t. If you want the safety and security of investing in the US Gov’t you sacrifice little in the way of yield by buying savings bonds.

What you get back is you can sell the bonds back to the government anytime after 6 months and the only penalty is the loss of 3 months interest. So you can invest now get some small yield and keep it if rates fall and sell it if they rise. Since you get all your initial investment back – there is no downside.

Danny
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Danny
August 30, 2009 11:21 am

Mikey, for details on how the I bond interest is calculated, check out
http://www.treasurydirect.gov/indiv/research/indepth/ibonds/res_ibonds_iratesandterms.htm

Elissa Stein
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Elissa Stein
January 28, 2009 1:58 pm
dear rose- for more information on options investment, google bernie schaeffer. His website has excellent options education and analysis, much of it for free. He has been trading options for approximately 30 years. There are many options trading services, too. Schaeffer wrote an excellent options trading book in the mid-90’s called The Options Advisor. Another good book is Trade Your Way To Wealth by Bill Kraft.( basic trading strategies). Most investment websites have extensive, free tutorials on options trading. Best of luck to you. Don’t try it until you understand it thoroughly. It is best to start by paper trading.… Read more »
Gravity Switch
Admin
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January 28, 2009 9:37 pm

Well put!

SageNot
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SageNot
January 28, 2009 10:11 pm

Well put Harry, brings back memories of the ’80’s when I indeed was a Futures Freak. But we also have T-Bond options on the CBOT exchange, so that if you’re wrong, you’re risk exposure is limited.

Personally speaking, the USA is not Japan, but I can see why many folks are wondering with Pelosi, Reid & Frank pulling Obama one way while the sane folks in Congress are trying to pull him in the opposite direction. Since the sane folks are not in the majority, we’re losing ground daily.

Sigh!

Gravity Switch
Admin
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January 29, 2009 9:30 am
Well put. The Fed can do a lot to prop up prices of long bonds if they really go that route, as they’re saying they may (in an effort to keep real interest rates low and stimulate the economy). The “bubble bursting” folks might argue that this will just lead to inflation (they’re creating more money to buy this debt) and dollar devaluation, and that they can’t make up for China or Japan or the oil states if they dump treasuries (not that anyone really knows if this will happen). But yes, you hit the nail on the head —… Read more »
Gravity Switch
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January 29, 2009 9:43 am
Thanks for sharing the idea. Just FYI for everyone: If you buy an EE bond or an I (inflation adjusted) bond you do get an extremely low rate right now, and that rate is fixed — unlike older savings bonds, the new ones don’t have rates that adjust every year. I bonds that you buy now have a rate of .7% plus whatever their inflation adjustment is, EE bonds are 1.3%. The average interest rate for a one-year CD is just over 2.25% at the moment, and some FDIC-insured savings accounts yield close to 2%. I used to see inflation-protected… Read more »
Blurpie
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Blurpie
January 29, 2009 8:56 pm

So, you go for a synthetic position: you can go long on a call and short on a put, thereby canceling out volatility fluctuations. Of course it does take a serious stomach should the position turn against you… A September 35 call long/35 put short position would be a good starting point, when TBT re-tests the 40 USD dollar, from which it last rebounded (support).

Shawn
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Shawn
January 31, 2009 6:33 am

While it is true that the I bond is currently paying a fixed rate of 0.7% – the inflation rate as of november is 2.46% meaning that for the first six months of ownership you get 5.64%.

And that is a pretty good yield – with no downside.

mikey
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mikey
August 28, 2009 4:55 pm

sorry, just a newbie here but how did you derive 5.64% from what you list above?

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