Jaded Thinking: Inevitability

We have many ways of referring to the idea of inevitability I'm going to dive into here, from the popular and religious to the mathematical and scientific:

• "You Reap What You Sow"
• "What Goes Around Comes Around"
• "To every action there is an equal and opposite reaction."
  (Newton's Third Law of Mechanics)
• "Energy can neither be created nor destroyed. It can only change forms." (The First Law of Thermodynamics)

With each of these concepts of inevitability in mind, let's consider a bit of recent history along with what we know about our own political and cultural tendencies and I think you'll agree that while we may not be able to precisely pinpoint the timing of specific outcomes, there are several inevitabilities in play that are worth our understanding and preparation (and in some cases point to investments which are likely to prove profitable in the future).

• National Debt and Treasury Yields: The full effect of Reagan-era tax cuts wasn't felt until the wave of investments that followed turned profitable during the Clinton era, but the few short years of budgetary surplus that followed were followed immediately by profligate government spending that is only going to increase sharply in the near term so long as it can be repackaged as "economic stimulus" by the legislative and executive branches. For nearly all of 2008 as the credit crisis deepened, fear drove a flight to quality in the form of US Treasury Bonds, pushing yields down to historic lows and effectively granting us a limited-time opportunity to borrow at near-zero rates. While the Fed has been talking up the notion of "buying Treasuries at the long-end of the curve" the reality is that the best they can hope for is a smooth rise in yields as risk appetite returns and Asian investors demand higher returns for T-Bill investments. ETFs like TBT and PST are the most convenient ways for retail investors to capitalize on rising yields (but keep in mind that because they are 2x levered instruments they should be looked at as a short term trade rather than a long-term holding), and a strategy of buying on pullbacks and selling on yield spikes has rewarded patient buyers nicely each time so far this year. With tax revenues likely to be down substantially in the near term even as government spending spikes, there's so much inevitability to this trade that your timing doesn't have to be perfect to exploit it. Unfortunately, the flip side to this inevitability is that eventually tax revenues, inflation, or both will need to increase sharply by the end of the decade to reach equilibrium again.

• Deflation and Inflation: Apart from the commodity bubbles that mostly popped last year (Gold is the stubborn exception but as I've discussed before that collapse in the near term is inevitable as it can't avoid at least a partial failure to live up to all the supernatural qualities ascribed to it--assuming governmental response is at least minimally comprehensible), we've seen significant deflationary pressure pop up in the global economy since at least the tech collapse in 2000 (and some would argue since the early 90s when Japan's asset bubble popped and the first large fed funds rate drop helped create the overheated tech bubble in the first place, but the exact timing isn't as important as recognizing the broader trend here). At this point, it's entirely rational to believe that the aggressive Fed response that lowers its fund rate to effectively zero will inevitably result in some inflation down the road. Absent any extreme shock treatment that would chase out all foreign investment in T-Bills and drive the yield above 20%, the soonest we would see signs of that inflation is 2010 and if history is our guide it will be more like 2012 or 2013 before real worries set up. Because of this lag time, any investor looking for an inflation hedge right now should consider investing directly in Treasury Inflation Protected Securities (TIPS) or in related ETFs like TIP which both offer long-term inflation protection. Most 401(k) plans offer access to TIPS auctions and secondary markets as well. Although there are no guarantees we've reached the bottom for commodities like oil and natural gas, those with more risk appetite may want to consider scaling into ETFs with exposure to the oil and natural gas stocks that have been beaten down to historic lows. I've been playing to the inevitable recovery in this sector via the United States Natural Gas Fund (UNG) and ProShares Ultra Oil and Gas (DIG) which is 2x levered so it's more of a trading vehicle than UNG, but there are lots of other ways to play the "reflation trade" that are much less risky than gold. Eventually, inflation will set in and these commodities are nearly always among the first to reflect it - accumulating exposure to them as they hit new historic lows is a great way to exploit the deflation/inflation cycles that are playing out now.

• Government interventions with large financials: As we've seen with the TARP program and its offspring, including the new program to be unveiled on Monday by Treasury Secretary Tim Geithner, the temptation for government to change the rules of the game with little warning has proven impossible to resist thus far--and the resulting uncertainty has sent so many investors to the exits that even the most healthy financial institutions have taken a huge hit in stock price and private investment that might have stepped in has been sidelined. If Monday's news is followed up with reinforcing actions that let investors of all means feel confident in what boundaries will be respected by future government action, it may finally be possible to rally from here as all the sidelined cash gets finds solid reasons to get back in the game. So much damage has already been done via backtracking and rules-changing that it will take an enormously focused effort with a strong spokesperson and a track-record of action that passes more than a few public tests before snakebitten investors will return. That's led to some historic if highly speculative buying opportunities and while I'm willing to incur fairly heavy losses along the way, I'm not going to make specific recommendations right now except to say that buying a few shares of beaten-down stocks in a few financials could be immensely profitable over time. Spend only what you're willing to completely lose, and don't bet it all on one name. My most speculative bet right now is on Citigroup (C) and my biggest return so far is on Barclays (BCS) where I'm currently sitting on a gain of well over 100% from a small purchase on 1/23 at the height of British bank nationalization fears. I'm nowhere near breakeven at this point, but I'm well positioned to exploit the coming move over the next year from capitulation/despondency/depression to hope/optimism as we swing back upwards again on the wave action that results from the psychology of asset cycles (I like Jeff Bernstein's model the most, but there are lots of others that are similar). It's quite possible that Friday was the final turning point out of the bottom, but we won't know for sure until bank stocks have already risen 5x from their lows and will take may more years before handing out the next 500%. The fact that so many financial CEOs last week have talked about how quickly they want to get out of TARP is a good sign that we may be nearing the end of the intervention - let's hope Monday's plan is the last news on the subject for rest of the year. If it isn't, the 1930's cascading crashes scenario will be all but inevitable. I'm rooting for a response that bears more resemblance to the 70s - ugly but more sideways than up or down. It's more tradeable, and eventually a combination of high interest rates and inflation signals its exit to begin the next real bull market that by about 2020 or so will finally take out (on an inflation-adjusted basis) all the highs set in 2007-2008 regardless of whether we have a 30s scenario or a 70s scenario in the interim)

For those that are willing to scale into and stick to bets on what we all know is inevitable eventually, the long-term reward for speculation on the date and price at which an asset class has reached at the height of market pessimism will will be huge but it will be commensurate with the risks that must be taken to make the investment and stick with it. Perfect timing is unlikely and patience will be sorely tested until the bearish traders working against you capitulate after the sentiment turn is finally identified. Wyckoff suggests the last stage of accumulation is a final drop that shakes out the weak longs and fatally traps the remaining short interest and Friday's action is the first time I've seen that king of pricing action sustain a full trading day since the start of the year. A confirmation of that action again on Monday might finally take us to the end of Phase B and into a clear "Creek" that stays confined within a much narrower trading range until the final plunge down and spring, which I think are likely to coincide with the next round of quarterly earnings reports in April. Buying that bottom will be hard to do until that final bear trap has sprung and pricing action has gone up from the massive short squeeze that follows, but as long as Obama's administration resists the temptation to change the rules again, the spring will work just as it did last week, with bearish pessimism driving double-down denial until the upward momentum is inevitable again just as the downward momentum became inevitable last spring to those who were paying attention.