Kass: Short Bonds

Doug Kass

08/04/10 - 02:00 PM EDT

This blog post originally appeared on RealMoney Silver on Aug. 4 at 7:52 a.m. EDT.

As stocks begin to challenge my upside S&P 500 target of 1,150 (in a range between 1,025 and 1,150), I would now reduce stock positions in the belief that shorting the U.S. bond market, via a ProShares UltraShort 20+ Year Treasury (TBT) long, provides a better downside risk/upside reward ratio than owning the S&P now.-- Doug Kass, "A Risk-On, Risk-Off World"

I would not get caught up in the optimism that has surrounded the sharp ramp up in the indices since early July.

Indeed, in yesterday's opening missive, I argued to further reduce long exposure as we traveled toward the higher end of my expected second-half trading range in the S&P.

I continue to believe that the July 1 lows will not be revisited in the months ahead as the hyperbole surrounding a double-dip in the domestic economy has abated, along with steady improvement in certain risk metrics and risk markets (e.g., junk bond yields down, euro up, industrial commodities higher, two-year swaps down).

Nevertheless, the ambiguity of the economic soft patch grows daily and was reinforced by Tuesday's sluggish data (factory orders, pending home sales, personal income and spending were all weak). Moreover, a reduction in inventories and some other influences now point to a revision of second-quarter GDP to under 2% later this month.

Since the generational low, I have argued that we are in a period of inconsistent and uneven economic growth that will be difficult for corporate managers (who do not have pricing power and face tepid top-line growth) and investment managers to navigate. In this anticipated sloppy setting, it will sometimes appear, in the quarters ahead, that we are reentering a recession. At other times, it will appear that we are reentering an expansionary phase.

Lumpy growth and the emergence of nontraditional headwinds (fiscal imbalances at the federal, state and local levels, higher marginal tax rates, a costly and burdensome regulatory backdrop, etc.) will serve to cap the market's upside.

Supporting the market (among other factors) will be low interest rates and reasonable P/E multiples (especially when viewed vs. generational low interest rates and quiescent inflation).

As well, the risk premium (S&P earnings yield less the risk-free rate of return in fixed-income) is at the highest level since 1980, when the bull market started. This means that stocks are cheap relative to bonds and/or bonds are way overpriced and possibly in bubble territory.

As I wrote yesterday, I tip in favor of shorting bonds over being long stocks. I believe that my downside in a bond short is limited and, if stocks rally, the reasons behind that rally (economic clarity) could produce a larger drop in fixed-income than a gain in equities.

How expensive are bonds? Consider, that at a 2.89% yield on the U.S. 10-year note fixed-income is priced at a P/E multiple of 34.5x (the inverse of 2.89%) against the S&P's P/E multiple of only 12.0x.

Regardless of one's views, erring on the side of conservatism seems to be the preferable course of action, especially after the sharp rise in the U.S. stock market.