Bear markets are rotational.

During a bear market, stocks rarely head lower en masse. Instead, the damage usually occurs on a sector-basis, with one group getting slammed after another. The recent carnage is no exception.

First up were the homebuilder stocks in early 2006. Then came the mortgage lenders in early 2007. The next victims were the big banks in late 2007. One by one, each sector was brutalized.

And you’ll never guess who’s next.

Long-term treasuries.

When the credit market first locked up in August, investor sentiment shifted in a big way. For many investors, the issue was no longer a return ON their money, but simply the return OF their money. Treasuries, widely held to be the only truly risk-free investments in the world, became the investments of choice.

Investors started piling in, kicking off the biggest rally Treasuries have seen in years.

You can see how Treasuries plunged as the stock market began to stabilize in March. However, this recent drop is only the beginning. The Federal Reserve’s aggressive rate cuts have resulted in Treasuries yielding less than the rate of inflation. In real terms, this means that investing in “risk free” bonds means losing money.

Should the stock market stabilize enough for investors to really start shifting their assets back into equities, the Treasury market will plunge dramatically. The Fed’s rate cuts alone foretell an end to the rally in Treasuries since the latter no longer offer any “real” return other than the peace of mind that comes from knowing you will definitely get your money back.

I’m not the only one who’s noticed this situation. Bill “the Bond King” Gross recently told CNBC that “Treasuries are the most overvalued asset in the world, bar none." Gross is putting his money where his mouth is too. He’s put 20% of his $125 billion fund’s assets into derivatives shorting long-term Treasuries.

There are a number of ways of profiting from this situation. The simplest would be to buy gold, which will soar when investors dump Treasuries thus increasing the downward pressure on the dollar. Or you could buy commodities which generally do well during times of increased inflation.

However, the most direct means would be to buy a fund that returns the inverse of Treasuries’ performance. ProFunds recently unveiled three such funds. You can read about them here.

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Graham Summers

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