Bond ETFs Find Favor as Economy Stalls

Although you would never guess it from all the bullish sentiment on Wall Street right now — with margin borrowing on the NYSE at levels not seen since the 2007 bull market top — bonds have been outperforming stocks for months.

Since early February, the iShares 20+ Year Treasury Bond ETF (NYSE: TLT) has climbed 6.6% versus a 2.6% gain for the SPDR S&P 500 ETF (NYSE: SPY).

This trend is set to continue. With “QE2″ coming to a close, investors can no longer ignore the constellation of concerns that plague the market: The lack of leadership by cyclical sector groups, the reliance on anti-dollar “carry trades,” poor breadth, eroding economic fundamentals, and short-term overbought signals. Industrial commodities have also been on the slide — including lumber and copper.

“Safe haven” Treasury bonds are poised to build on their recent strength, a sign that the increasingly pessimistic bond market isn’t convinced that the economy is firing on all cylinders. The same can be said of options trading investors, who continue to bid up protective put options and keep Wall Street’s “fear gauge”  – the CBOE Volatility Index (CBOE: VIX)  – off of its lows despite the push to new highs for the S&P 500 on Tuesday.

This suggests the bulls are in for some disappointment as the economy stalls just as the Fed is forced to remove its policy stimulus. Obviously, this would be bad news for risky assets.

You can see this in the way Citigroup’s U.S. Economic Surprise Index has taken a huge plunge after peaking in early March. The index looks at economic releases and compares them to expectations. When the data comes in better than expected, the index will rise. When the data is weak, the index drops. Stocks also tend to parallel the index’s movements — but lately, the two have headed in opposite directions, as shown in the chart provided by Jason Goepfert of SentimenTrader.

The bond market is keying off of this drop in the economic outlook. For investors looking to latch on to the developing medium-term rally being put together by the bond market, the TLT is a great pick since it is heavily traded and very liquid. It also carries a relatively low expense ratio since it is passive- managed and tied to the Barclays Capital U.S. 20+ Year Treasury Bond Index.

For those looking for more oomph, the active management bond pros at PIMCO are preparing to launch a new contender into the field, the PIMCO Total Return ETF (PTTDX) — which will be the exchange-traded counterpart of the group’s flagship PIMCO Total Return Fund (MUTF: PTRRX).

For now, I’ve recommended that my newsletter subscribers build a position in the leveragedDirexion Daily 20+ Year Treasury Bull 3x Shares (NYSE: TMF) — which returns three-times the daily return of the TLT fund. With the economy under pressure and bonds piecing together a healthy medium-term rally, the TMF should enjoy a nice pop. A simple return to its 200-day moving average, which hasn’t been hit since last November, would be worth an 11.2% gain from current levels.