Yields on the Rise Means Techs are in Play (TLT)

Before we commence with the day’s activities, there’s a profound misconception floating about the investment blogosphere regarding the relationship between stock and bond markets that we feel should be addressed.

In short, it’s widely believed that a back-up in interest rates is a net negative for stocks – that stocks become less attractive to own as the rate on bonds begins to compare more favorably with the dividend yield on equities.

And the argument has its logic, to be sure.

But history tells a different story. And where history battles the heady winds of intellectual rigor, we stick with history.

Because man is not an exclusively rational animal.

MAN-RATIONAL

Oh, my!

So let’s consider a little history.

To begin, let’s have a look at better than 50 years worth of data that includes both the Fed Funds Rate and the Ten Year Treasury Note along with a highlight of all those periods in which the latter was rising.

US-INTEREST-RATE-1962-PRESENT

Since 1962, the ten year has been in a rising trend for the majority of the time, as seen from the blue shaded areas on the chart. The market as a whole, as we know, has also climbed tremendously during that period. But how has the market fared during those exclusively highlighted periods when rates were on the rise?

According to a study undertaken by CIBC World Markets that includes data from 1993 until the present, the S&P 500 climbed an average of 24.21% during the first six months of every rising rate cycle, 22.31% during the first year after the cycle began, and 16.45% over the whole term of the cycle.

That is to say, investors did not suffer, on average, while the cost of the ten year note was declining. If they stayed invested in the broad market during each of those periods in question, they gained 16.45% for their troubles.

Not bad.

But will it be true this time? Will rising rates bring strong equity returns?

Nobody knows. And certainly if we’re now in the midst of a long-term, secular change in trend, the realities ‘on the ground’ may turn out to be somewhat different than they have in the past.

All the same, we’re betting on the data to hold true for at least the first six months of the current cycle, and we’re also assuming the cycle has already begun.

So how do we play it?

We’re going to return momentarily to the above mentioned CIBC World Markets study to garner some more sector-specific information. Particularly, we’re interested to know if there were any corners of the market that fared better during a period of rising rates than any other.

And the answer again comes to us in chart form. Take a look –

SP-OVER-AND-UNDER-PERFORMANCES

As the above data demonstrates, Information Technology (IT) stocks were the best performing group when all three time frames were considered (6 months, one year, full cycle). Over six months, IT bested the index 75% of the time, after a year, 86% of the time and for the full duration of the tightening, 67% of the time.

The Industrials had an equally consistent record of outperformance, but no other group matched IT’s overall percentage gains for each of the periods in question.

Have a look –

SP-500-PERFORMANCES-WITH-INTEREST

In short, if we are expecting a back-up in the ten year note, as we are today, it behooves us to set up a trade using the IT sector as a long component of that trade, and to initiate it for as long a time frame as possible in order to ensure that all three study periods are ‘activated’ and the technology sector is given all the time it needs to prove itself statistically. What we do thereafter, to hedge the trade, is an open question.

Hedge? Why Hedge?

Before we indicate how exactly we plan to place our bet, a quick word on the art and science of hedging.

The investment game, as we play it, places us in the face of a number of risks. Options Trader Elite is essentially an options trading service, generating lucrative trade ideas on a weekly basis for hundreds of thousands of readers. But because of the leveraged nature of options, the prospect of losing money – and potentially a great deal of it – is always before us.

We’d therefore be remiss if we just tossed out random money-making ideas that sometimes hit and sometimes didn’t. Nor do we believe that we’d be able to grow our readership at the rate we have if we acted in so reckless a fashion.

We appreciate that performance in the investment game is measured in years, not weeks or months, and certainly not by the trade. And that means every trade must offer a reasonable return without exposing the trader to unreasonable losses – because there will always be losses; that’s unavoidable. And that’s the key here.

The question of success in this business resides entirely in the minimizing of losses. Nothing more. As Warren Buffet says – “Don’t lose money.” That’s the beginning and end of the trading game. And that’s precisely why we hedge.

Trade Details

Hedging affords us a means of minimizing losses. We’ll win some and we’ll lose some, but if we’ve planned well, it’s our hedges that will save us over the long haul.

That said, let’s return to business.

We believe the bond market is unwinding (with rates going higher) and the stock market is climbing. If history holds true, we should therefore see the IT sector leading the pack. When it does, we’re going to turn it into a huge profit for us using the following play…

[mepr-rule id=”994″ ifallowed=”hide”][mepr-unauthorized-message][/mepr-rule]

[mepr-rule id=”204″ ifallowed=”show” description=“options_trader_elite_members_only”]

We’re going to use two ETFs to set up our trade, the iShares 20+ Year Treasury Bond ETF (NYSE:TLT) and the Select Sector SPDR Technology ETF (NSE:XLK), and we’re going to give them as much time as the options market allows, until January of 2017.

Options Trader Elite recommends you consider the purchase of the XLK January (2017) 47 CALL for $2.38 and the sale of the TLT January (2017) 140 CALL for $2.39. Total credit on the trade is $0.01 per pair.

[/mepr-rule]

[mepr-rule id=”988″ ifallowed=”show” description=”executive_lounge_members_only]

We’re going to use two ETFs to set up our trade, the iShares 20+ Year Treasury Bond ETF (NYSE:TLT) and the Select Sector SPDR Technology ETF (NSE:XLK), and we’re going to give them as much time as the options market allows, until January of 2017.

Options Trader Elite recommends you consider the purchase of the XLK January (2017) 47 CALL for $2.38 and the sale of the TLT January (2017) 140 CALL for $2.39. Total credit on the trade is $0.01 per pair.

[/mepr-rule]

The techs just broke to new all-time highs yesterday!

With love of the hunt,

Hugh L. O’Haynew

See what people are saying...

  1. steven melmed

    Hugh,
    How much does my account have to be? I just signed up a few weeks ago, with $10,000 in my account. I tried putting on the pairs trade with XLT and TLT – I completed the XLT long call, but I was trying to sell the TLT call and was informed I did not have enough in my account! Simple math will tell you 100 shares at 140 equals $14,000. So I would need to have that available to complete the transaction. So I could not complete the trade and now have no hedge. Could you please consider an account with $10,000 in it in the future when you put on the trades?
    Thanks,
    Steven

  2. Adel

    I don’t understand why you guys still think that interest rates are going up? The debt is just too high to increase rates. Maybe, just maybe a quarter point, symbolically. I believe we are already in the Japanese era. Until we pay off the debt, no rise in rates. And we will likely never pay off the debt. Unless of course the next major technological breakthrough is manufactured solely by the U.S. Government (I don’t know, flying cars, space vacation cruise ships, whatever).

  3. Brent Richardson

    You guys alive? haven’t seen a letter in a while?

Share your thoughts...

We encourage people to join in on the discussion. Please keep in mind however, that all comments are moderated according to our comment policy, and all links are nofollow. Let's keep the conversation professional and meaningful.