The new view of the world is that we’re going to see lower interest rates for a very long time.
In much of the world, rates are negative, and you have to pay a little to some governments just for a promise to get most of your money back at maturity.
The President is pounding the table for lower interest rates to boost the U.S. economy, and the Fed is openly speculating about the negative impact of slowing in the Eurozone and a protracted trade war.
The only ones that even hint of something different are the permabears – the folks who always talk about doom, gloom, and the end of the world.
Here’s the critical question we need to ask ourselves right now…
The Track Record
They were right in 2007 and 2008 and made a fortune.
Many of them have lost a good chunk of what they made by being too bearish too long, but at that moment, they made unbelievable amounts of money.
I’m a huge fan of Nassim Taleb – the trader and mathematician who wrote Fooled by Randomness and several other classic investment and life advice books.
He’s among those who made a fortune on both of those occasions, but unlike many others who share his pessimism, he’s been able to keep his.
He did this using what’s called a black swan strategy.
He looks for the things that nobody thought would happen and made small bets that they would.
He understood the math behind the fact that if the payoff is high enough, then it’s wildly profitable to make small bets on unlikely events.
“Everyone” is often wrong, especially when it comes to the market, and the probability of a black swan event is actually higher than the conventional wisdom would indicate.
I think that’s exactly what we have in the Treasury Bond market.
The price of the long bond ETF – iShares 20+ Year Treasury Bond ETF (NasdaqGM:TLT) – has shot from $130 to $145 in just a month. A move of over $10 in the stock markets is unusual, and it’s even rarer for a safe asset like U.S. government bonds.
In November, it was all the way down at $115. No allegedly rational observer thinks we will get back to that level anytime soon, so that’s exactly the bet I think we should make.
There’s no need to make a big bet. A small bet will pay off more than enough to make it worth placing.
We could outright short TLT, but there’s a real chance of permanent painful disaster for doing so.
Sometimes the crowd is right, and the key to executing a black swan strategy is making sure the losses are not painful enough to notice.
To do that, we have to go to the options market.
We also want to buy some time. A series of short-term bets could add up to a tidy sum before something finally disrupts interest rates, and we get paid.
Fortunately, the Chicago Board Options Exchange has contracts going all the way out to January of 2021, so we can just make one bet to cover 16 months.
Before I suggest which option to buy, let’s talk about some of the reasons treasuries could fall back below $130 and maybe even all the way back to $115…
Reasons for the Improbable
First, keep in mind that $115 implies long-term interest rates of just a little over 3%.
That’s not an unreasonable price for a long to anyone, even the U.S. government, with a 20- or 30-year maturity.
The bond market could, over time, decide to reprice the risk of lending to the United States – particularly if (or when) our deficit just keeps rising.
Second, the permabears might be right this time.
Printing all of this excess money and keeping rates lower for longer just might cause an inflationary surprise, and no central bank on the planet has the tools to fight that if it does occur.
We could see developments in the Middle East that cause oil prices to skyrocket and push inflation and interest rates higher.
China could sell Treasury Bonds as a trade tactic, putting pressure on U.S. bond prices.
A sweep of the White House and Congress by the Democratic Party led by the far-left would almost certainly cause a repricing of risk, as the spending programs and monetary policies they espouse are viewed with a great deal of skepticism by most economists.
A sweep by the GOP could spur selling as markets could develop fears that continued tax cuts, which could then cause the deficit to climb to dangerous levels…
You get the picture.
Finding the Best Bet
My main point here is that it doesn’t even take a few bourbons to develop very plausible and probable theories about why interest rates could jump up in price.
None of these possibilities are priced into the options contracts right now, even those worth 16 months until expiration.
My approach would be just to buy the first put strike with January expiration that I could buy for less than $1 a contract. Each contract allows us to sell 100 shares at the strike price between now and January 15, 2021.
We don’t need prices to fall all the way back to $115 to make money.
Options pricing is a three-legged stool with price, interest rates, and volatility being the main components.
Right now, volatility is very low, and a downward move would send volatility screaming higher, making prices multiple very quickly.
As an example, if we bought the January 2021 put for $0.80 last Friday and six months from now the price of the TLT fell to $113, our options could be worth as much as $3.15 if TLT volatility went back to the 52-week high.
An event on the magnitude of public dumping of bonds by China would send volatility screaming higher as prices collapsed, at which point we could see gains of 10 times our bet or more.
We make money from the price movement, and the volatility increases even if the option never actually trades at our stock price.
The key to making a black swan strategy work is to keep the stakes small, because they won’t all work.
If you executed a black swan strategy with a 50%-win rate, you would pile up unbelievable sums of money in fairly short order.
If I’m wrong, I want to lose a tiny amount, but if I’m right, I get a payoff that adds a nice chunk of change to my piggy bank.
Nobody thinks interest rates will go higher. For that reason alone, a small bet with a high payoff potential makes sense.
One More Black Swan Bet
Black swans happen, and if you have your money in the right place when they do, you can make ridiculous sums of money.
For example, take the story of a banker who bet on a remote strip of land in the Chihuahuan Desert.
All conventional wisdom had said it was an oil dead zone.
Not long after his purchase, a new survey was conducted that found the largest American oil deposit ever found.
20 billion barrels of oil, 16 trillion cubic feet of natural gas, and 1.6 billion barrels of natural gas liquids.
All told, an estimated $1.4 trillion worth of energy was beneath his “dead zone,” and thanks to breakthrough innovations in mining technology, all of it is recoverable.
This banker made the right decision at the right time and by reading this, so have you…
There’s an opportunity to take advantage of this development play. You can find out how just a small stake in that opportunity could end up as your own monumentally profitable black swan, right here.
To the Max,