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Leader of the Bonds is Tired

Bernie Schaeffer
Bernie Schaeffer
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I've been a proponent of the bond market for nearly a year now, turning bullish on the market segment last December. For the past several months, I've recommended devoting a portion of one's trading portfolio to bonds by capitalizing on the simplicity of the iShares Lehman 20+ Treasury Bond Fund (TLT). In fact, the SectorFlex Alert Service that I run began putting TLT in its portfolio dating back to May 2004. It's time for another look at bonds, but this time I believe a bit more caution is warranted. My reasons for this are six-fold, as outlined below.

1.  Price action moving in favor of the bears..

Between June 2004 and July 2005, TLT enjoyed a very respectable run higher, tacking on nearly 20 percent. Things got a little hairy for the fund in the waning days of summer, as it tried to overcome double-top resistance near the 96 mark, along with the psychological resistance implied by the 100 region. Since then, a brief run higher in late August notwithstanding, TLT shares have been slowly slipping. This downward momentum has forced the security's 10-week and 20-week moving averages to each reverse lower, forming a bearish crossover in the process.

2.  Long-term support breaking down..

TLT closed September beneath long-term support at its rising 10-month moving average. This was the fund's first monthly close beneath this trendline since July 2004, a poor harbinger for the shares.

3.  Declining put/call ratio..

Over the past month, TLT's Schaeffer's put/call open interest ratio (SOIR) has dropped from 6.08 (in the 93rd annual percentile) to 2.83, in the 26th annual percentile. While the fact remains that put open interest continues to outweigh call open interest nearly three-to-one among shorter-term options, SOIR advances have historically corresponded with TLT advances. As such, a declining SOIR reading is hardly a positive development. I'd advise caution with this line of thinking, however; if the SOIR decline is close to having run its course (the indicator bottomed very close to this level in late 2004), could this in fact be a buying opportunity?

4.  Declining short interest..

Since February 2005, short interest on TLT has been cut nearly in half to 11.9 million shares and is now at its lowest point since July 2004. What's more, this indicator is in a downtrend for the first time in its history. The combination of weakening TLT price action with the simultaneous bailout from short sellers does not bode well from a contrarian perspective.

5.  Attention from hedge funds is too little, too late. .

It's been a long time coming, but hedge-fund managers have finally turned bullish on the bond market after being extremely bearish on bonds for the first half of 2005 (according to monthly data from Van Hedge Fund Advisors). The latest monthly survey showed 61 percent were positive on bonds, while just 28 percent were negative. The first notable jump in the bullish percentage (from 33 percent to 50 percent) occurred in August when TLT was peaking. In other words, this group managed to turn bullish right at the top and remained so during the fund's early stages of decline.

On the other hand, according to an article in this weekend's Barron's, the lastest Commitment of Trader's data shows that the number of short speculative positions relative to longs among commercial hedgers is among the biggest since October 1987, when stocks crashed and bonds rallied strongly.

6.  Mutual-fund outflows from bearishly oriented bond funds..

We have noted major outflows in the Juno Rydex Fund (RYJUX), a mutual fund designed to profit from bond-market declines. Since early April, assets (total invested money, without taking into account the absolute shifts in net-asset value) in the Juno fund have dropped by about 25 percent. This decline in bearish bets, just as the price action in the bond market is showing signs of eroding, could represent the beginnings of a "slope of hope" that may open bonds up to some vulnerability. On the other hand, the level of assets in the Juno fund is still huge, despite this decline. The latest Rydex data showed that Juno is the leading index tracking fund in the Rydex family, boasting 29 percent of all index-fund assets.

To wrap up, there may still be reasons to like bonds at this juncture, but there should certainly be more caution. The bullish factors supporting TLT (and the bond market in general) are not as strong as they were at the beginning of the year. Yet one theme continues among Wall Street analysts - "stocks will outperform bonds." A possible contrarian theme is that bonds will outperform stocks. But a more likely scenario that could play out is stocks experiencing a significant decline while the bond market continues to trade in a range or suffers only a minor setback. That being said, one might consider moving a portion of their holdings from bonds into gold by investing in streetTRACKS Gold Shares (GLD). I'll end with yet another reminder that the biggest area of vulnerability is in the stock market, specifically the "mega-cap" names.

Bernie Schaeffer will be available to take your questions until Monday, October 24. Please use the form below to submit your questions.

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