Goldsmith comment: Today, we're continuing our interview with trading guru Jeff Clark.
As his Short Report readers know, Jeff has an incredible knack for booking big gains in a short time frame. Yesterday, he detailed the strategy behind his biggest winners of the last few months, including a two-week, 65% return.
Today, Jeff explains how he's trading higher interest rates and shares a few short ideas to watch...
Sean Goldsmith: Can you explain to new folks how rising interest rates are bad for stocks?
Jeff Clark: Well, there are a couple simple explanations...
First off, from a fundamental perspective, any company that's borrowing money to do business increases the cost of new funds. Secondly, it also increases margin rates on investors. Folks who are buying stock are paying a little extra, so they demand higher potential returns.
But really, the main crux to this is bonds that offer higher interest rates are much more competitive relative investments to stocks.
So you have a situation – and I just pointed this out in Growth Stock Wire – like back in 1987. At that time, stocks had this unbelievably remarkable rally. I think they were up 25%-30% by the middle of the year, and interest rates were also spiking higher at the time. Interest rates were, I think, a little over 7.4% in early 1987... And by August, they were up around 9.2%. So you had this dramatic rise in interest rates as the stock market was going higher as well.
When we started 1987, stocks were relatively cheap and bonds were relatively expensive. And then those two movements, the higher rates and the higher stock prices, created a situation where bonds were relatively inexpensive and stocks were relatively cheap.
An investor looking to put new money to work could put money into a stock market that was overextended to the upside, where there was a significant risk of a correction, and where the upside potential was somewhat limited to that point. Or they could put it into the bond market, where the 30-year Treasury was offering 9.2%. So the Treasury bond became a competitor to stock prices.
You're looking at sort of the same situation now. We've had interest rates on a sharp rocket ride since last September. The 30-year Treasury bottom dropped 3.5%, and now it's up near 4.8%. That's a dramatic increase in a very short period of time. At the same time, you have stocks that have gone from 1,050 on the S&P last September to 1,325 now. That's also a dramatic rise in a very short period of time.
So we reversed the situation again. We went from a period where bonds were expensive and stocks were cheap, and now we have the opposite. Bonds are cheap and stocks are expensive. Somebody looking to put new money to work here can say, "Well, I can lock in 4.75% on essentially a risk-free basis on the Treasury bond market, or I can throw money into the stock market." The analysts are looking at about 1,375 to 1,400 on the S&P by the end of the year. Well, that's another 4% or 5% from here.
You've got risk in the stock market, and you have a perceived-risk-free rate that's equivalent in the bond market. The threat of higher interest rates is that you have a stronger competitor to stock prices.
Sean Goldsmith: One of the sectors that looks vulnerable here is the airline stocks, which have soared in the past few years. Do you think this classic "boom and bust" sector is ripe for a short sell soon?
Jeff Clark: Well, yes and no. Airline stocks aren't the same monsters they were years ago. Many of them have restructured their labor union agreements. They're a lot trimmer. There are a lot of things that are going well for the airlines at this point.
Now, obviously, historically, airline stocks have been losing investments. I think the aggregate net income for the industry is a loss since its beginning many, many years ago. So I'm not a big bull on airline stocks. And quite frankly, I'll use any excuse I possibly can to get out of flying, because flying has become such a hassle.
I'm not a big fan of the companies themselves, but at the same time, if you want to get from California to Paris, your only choice is to fly. So you're going to pay the prices, and you're going to put up with all the garbage you have to put up with just to be able to get around.
I don't have them on my list of stocks that I'm anxious to short anytime soon, but I think the folks who provide services to the airlines – folks like Expedia, Travelocity, or Priceline – those are interesting short sell candidates, especially as the momentum on those stocks starts to fall.
Look at what happened to Expedia recently. The stock was down 15% on an earnings mess. That sort of thing is more interesting to me than shorting the airlines themselves. I'd rather short folks who are providers to the airlines.
Sean Goldsmith: What do you think of Jim Chanos' much-publicized short bet on China... and on raw material producers like iron ore giant Vale?
Jeff Clark: Well, Jim and a lot of very smart hedge-fund managers are short China. And then, folks like Jim Rogers and a lot of other very smart hedge fund managers are bullish on China. So it's really tough to argue either way.
I think the main problem in China is it's tough to get accurate information, and you have to question the details that you have.
I've traded some Chinese stocks before, and I got mixed success with that. A lot of times, the stocks where I've made errors, I've made because the information I got or the data I got on the companies was inaccurate. They're subject to different reporting requirements than American companies, and it's difficult to trust the information that you get. Unless you have somebody over there who's watching the individual companies and can tell you first-hand that what is written in the reports is accurate, it's tough to make that call.
If Jim Chanos says short Vale, I'm not going to argue with him about that. He's a smart man, and he's certainly earned his medals in the market. He probably has that sort of information. As far as China, technically it's in a downtrend, and the momentum, obviously, is working to the downside, so he's got the wind at his back at this point.
Sean Goldsmith: Great. Thanks, Jeff. Are there any last words you'd like to share?
Jeff Clark: Well, right now, you have an interesting situation in the market, which is overextended. You have bullish sentiment that is truly off the charts, and interest rates that are on the rise, and all of this stuff looks remarkably similar to what happened in 1987.
And I remember as a broker in 1987 just banging my head on the wall multiple times between April and August, because I just could not get a handle on why folks were buying stocks in what I deemed was a very risky environment. And of course, that risk all came to pass in October, when the market crashed several hundred points and everybody got shaken out of their long positions.
And I hate to say we're headed to something similar to that, but I don't see how it can't occur that way, especially when you have so many folks right now conditioned to be buyers on any pullbacks at all, you have so many mutual funds sitting on very little cash, because they're forced or they're pressured to be fully invested at this point, and you have such wild investor sentiment on the upside.
We're making the same recipe we had back in 1987, and I know there's been several times since then where we can peg similar conditions. But the pivot is the rising interest rates. I think the rising interest rates are going to take their toll. Once the 30-year Treasury gets up around 4.9%... that's really the tipping point. And we're dangerously close to that right now.
So I'm anxious to get short. I have a couple short positions, and I'm underwater on that. But I haven't been aggressive on the short side, simply because it's been a fool's game to try to short the momentum behind this market.
There's a point that's coming, and I think it's coming soon, where we're going to pay the piper. And it will be a time to be all-in on the short side. I think we're getting close to that. We're not there yet, but when we are, I'm anxious to put some of these ideas we've talked about today to work.
Sean Goldsmith: Great. Thanks so much for joining us today, Jeff.
Jeff Clark: My pleasure.
Digest readers have read Porter's thoughts on rising interest rates and how those play into his End of America thesis. As you just read, Jeff is also watching this trend – and trading on it. His readers have doubled their money – or more – with short bets on Treasurys and long bets on "real assets" that profit as the dollar declines.
You can access all Jeff's research and his latest trade in the S&A Short Report. Click here for details.
Regards,
Sean Goldsmith
Miami, Florida
February 17, 2011Jeff Clark: This is the one number to watch... A couple short ideas... How Jeff sees the End of America playing out...