Are Inflation Proof TIPS Breathtakingly Cheap?

By: Mike_Shedlock

Inflation backed securities have been on a good run since November. Some still suggest that TIPS Are "Breathtakingly Cheap" .
At a time when central banks are attempting to prevent deflation, the hottest investments in the government bond market are securities that protect debt holders against rising consumer prices.

Inflation-linked debt from the U.S. to Japan returned 5.77 percent since November, including price gains and reinvested interest, compared with 1.55 percent for the government-bond market, according to indexes compiled by New York-based Merrill Lynch & Co.

“They're breathtakingly cheap,” said Mitchell Stapley, who oversees $22 billion as chief fixed-income officer for Grand Rapids, Michigan-based Fifth Third. “This one's going to take a while to come to fruition but I'm buying them so dirt cheap I'm willing to have a little patience.”

“There's been a lot of selling related to de-leveraging hedge fund stuff that just caused TIPS to get unbelievably cheap,” according to Kenneth Volpert, who oversees $180 billion in taxable bonds for Vanguard in Valley Forge, Pennsylvania.

Pimco co-Chief Investment Officer Bill Gross, who manages the world's biggest bond fund, recommended inflation-linked debt last week.

TIPS “can benefit if and when the government's efforts to reflate begin to take hold,” Gross, head of Newport Beach, California-based Pimco's $128.4 billion Total Return Fund, wrote in a note to clients on Jan. 8. While break-even rates suggest consumer prices will fall an average of 1 percent a year for 10 years, that's “possible, but not likely,” Gross said.

“TIPS are a great buy,” Vanguard's Volpert said. “The economy will start coming back, and risk will be taken again, and inflation expectations will work their way up.”

That's a lot of love. Inquiring minds may be asking "Is there another side to the story?" Indeed there is.

Please consider Market Action Abruptly Signals Renewed Caution by John Hussman.

My impression is that we are not near the point where there is any real risk of inflation, and we may very well observe negative near-term inflation rates (which is why it is important to be careful with TIPS that trade at a substantial premium to par, since the apparently high “real” yields on near-term TIPS can be eroded by deflation). TIPS can't mature at less than par, but if there is a deflation, the accrued inflation adjustment on these securities can be whittled down. Suffice it to say that we are holding TIPS not because we anticipate a near-term resurgence of inflation, but because the real, inflation-adjusted yields available over the next decade are quite high on a historical basis, and will adequately provide for the maintenance and growth of purchasing power over time, regardless of the near-term course of consumer prices.

On overall market conditions Hussman writes:

In recent sessions, we have observed a troublesome deterioration in credit default swap spreads among a number of major financials, which has prompted us to tighten our hedges in response. From a statistical perspective, what I've referred to as “early improvement” in our measures of market action has now been lost. The Strategic Growth Fund is fully hedged here, about half with pure long-put / short-call option combinations, and about half with what amounts to in-the-money put options (allowing the Fund to obtain a moderate positive exposure to market fluctuations in the event that the market recovers more than a few percent)

If we get the S&P 500 back down toward the 700 level or below, I would expect that we will begin taking on more market exposure on the basis of valuation, as we did in October and November. That said, I would expect that we'll be somewhat slower to do so, given the generally poor follow-through that we've observed in the recent market recovery.

As always, we'll respond to market conditions as they evolve. I recognize that my tone regarding the stock market has taken a quick turn toward a defensive posture, but that quick turn reflects what we've observed in various measures of credit distress and market internals. This is why I avoid forecasts. We move as the evidence moves.

I side with Hussman, on both snips.

Sitka Pacific is holding a position in TIPS and Treasuries via the treasury ETFs, (TIP, TLT, IEF). However, our position is cut by more than half from what it was for most of 2008. For us, at least right now, treasuries and TIPS are more of a hedge to other things we are doing as opposed to believing they are irresistibly cheap.

As for market conditions, it certainly does pay to be flexible. Sitka went from net long to fully hedged on January 7th as noted in S&P 500 Crash Count - Wave Four Triangle .

Sitka Pacific Hedged Growth Strategy is back to a market neutral strategy as of two days ago, as is Sitka Pacific Absolute Return .

This is a defensive position for us. We reserve the right to change out mind, without notice, at any time. Please bear in mind that E-Wave is just one tool we use and it is not even the predominant one. We take a large variety of technical and fundamental factors into consideration and caution against over-reliance on any one thing.

Fundamentally and technically the market is flashing huge caution signs. Neither the market nor TIPS are "breathtakingly cheap". Caution is warranted.

By Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com

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Mike Shedlock / Mish is a registered investment advisor representative for SitkaPacific Capital Management . Sitka Pacific is an asset management firm whose goal is strong performance and low volatility, regardless of market direction.

Visit Sitka Pacific's Account Management Page to learn more about wealth management and capital preservation strategies of Sitka Pacific.

I do weekly podcasts every Thursday on HoweStreet and a brief 7 minute segment on Saturday on CKNW AM 980 in Vancouver.

When not writing about stocks or the economy I spends a great deal of time on photography and in the garden. I have over 80 magazine and book cover credits. Some of my Wisconsin and gardening images can be seen at MichaelShedlock.com .

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