The Contrarian

Apparently I am the contrarian based on the following "insight" by Fidelity. A position I much prefer since the herd is often wrong and the herd realizes at best average performance.

Fidelity argues that many people are avoiding Treasuries due to anticipated inflation and the end of QE2, which means a large buyer of treasuries (the U.S. government) exits the market. Fair enough, this is an active debate in the market right now on which I happen to take the opposite view of slower economic growth and deflation dominating U.S. government buying trends.

Fidelity goes on to argue that every portfolio should have some exposure to Treasuries to reach the magical "efficient frontier" in which the risk/ reward of the portfolio is maximized. This is a powerful theory that has many positives points. But I have always had one problem with it: it assumes the markets are in a state of information efficiency that reflects the proper valuation. I humbly disagree with this assumption and believe that many securities are mis-priced due to either fundamental oversights, lack of research, herd movements, or even emotional entanglement.

Operating under the assumption that securities are always seeking the efficient price, but often not obtaining it, I ask a simple question. If through research you know a security is materially mis-priced, offering an opportunity for a move that far exceeds the market performance, and you can identify a catalyst that will likely cause the security to become priced efficiently (such as reporting earnings), why would you not significantly over-weight this security in your portfolio?

Granted this is hard to do and requires significant insight into both the fundamentals of the business and the market expectations. But it is accomplished daily. Therefore, I much prefer to look at Treasuries through the following prism: The majority of the market appears to focus on inflation risk and the exit of a major buyer, likely pushing down prices of Treasuries. If my analysis of deflation and an economic slowdown proves correct then Treasury prices likely rise (yields fall) as the market prices in this scenario. Furthermore, a fall in the stock market likely hastens a rally in Treasuries since money likely floods into Treasuries.

To quantify it, at current yields a 1% decline in the yield on the 30-year treasury results in a 15+% increase in the price. So if the yield moves from 4.3% to 3.3%, I should see a over a 15% increase in my principal. Not bad, especially if stocks decline amongst a deteriorating earnings outlook and worries about deflation. This is why I have such a large position in 30-year Treasuries and also highlights my level of conviction about the risk of deflation increasingly dominating the markets for the remainder of this year.