The Best Way To Hedge Against A Stock Market Decline

Includes: BAB, EDV, SPY, TLT, ZROZ
by: Eric Parnell, CFA

For investors seeking a high quality, low risk way to hedge their portfolio against a stock market decline, an attractive opportunity is now presenting itself to either establish or build upon such a position. Long-term U.S. Treasuries, which have produced an excellent track record in this regard over the last several years, have endured a tough stretch over the last few days. Following the unbridled stock market euphoria that came with the U.S. economy adding a few more low quality jobs than expected in Friday's jobs report, long-term U.S. Treasuries took it on the chin. Fortunately, this recent pullback has presented an attractive buying opportunity for those investors seeking to hedge their stock allocations.

Over the last four trading days since last Friday, long-term U.S. Treasuries as measured by the iShares 20+ Year Treasury Bond (NYSEARCA:TLT) have declined by -3%. But this pullback represents a modest retracement of the near +9% rally that began on March 8. And the TLT has seemingly found solid support at its 200-day moving average. This support is complemented by several other support levels also in close proximity including its rising 50-day moving average. These forces may help limit further downside in the coming days.

A variety of other factors are supportive of buying long-term U.S. Treasuries at this juncture.

First, long-term U.S. Treasuries continue to follow fairly predictable yield patterns. For example, since the 30-year Treasury yield entered into its current range between 2.50% and 3.50% in the summer of 2011, it has demonstrated responsiveness to each quarter point yield level within this range. And at the moment, the 30-year Treasury yield has risen to the 3.00% threshold and appears to be holding support at this level. Even if it were to break, it would quickly find additional support from the 50-day moving average at 3.03%. Thus, odds favor an eventual return by the 30-year Treasury to the 2.75% yield level at some point in the near-term, which would be supportive of the TLT along with other long-term U.S. Treasury instruments such as the Vanguard Extended Duration Treasury Index (NYSEARCA:EDV) and the PIMCO 25+ Year Zero Coupon U.S. Treasury Index (NYSEARCA:ZROZ)

Second, long-term U.S. Treasuries continue to represent arguably one of the best ways to hedge against declining stock prices. Since the outbreak of the financial crisis, when stocks (NYSEARCA:SPY) have fallen into decline, long-term U.S. Treasuries have rallied strongly. But what is perhaps more notable is that when stocks are rallying, long-term U.S. Treasuries have shown the ability to also participate to the upside.

This has been particularly true since the beginning of 2010 when the markets first began to settle down amid the Fed's QE1 stimulus program. Over this time period, long-term U.S. Treasuries have had a meaningfully strong -0.72 weekly returns correlation versus the stock market as measured by the S&P 500 Index. But it is the differentiation of returns where the true benefit of long-term U.S. Treasuries can be seen. For example, in the 73 weeks since the beginning of 2010 when stocks have fallen, long-term U.S. Treasuries as measured by the TLT have rallied in 67 of those weeks with an average return of +1.79% versus the average stock decline of -1.81%. But over the 103 weeks where stocks have gained, long-term U.S. Treasuries have also gained in 33 of these weeks with an average return of -0.82% versus the +1.68% average gain from stocks. In short, long-term U.S. Treasuries have during stock market corrections provided twice the return to the upside than they have given up during stock market rallies to the downside. This has netted strong returns for long-term U.S. Treasuries at a time when all eyes have been on the stock market.

Lastly, long-term U.S. Treasuries continue to follow what has become a consistent QE pattern. Basically, long-term U.S. Treasuries have typically peaked in and around the time that a new balance sheet expanding monetary stimulus program by the U.S. Federal Reserve has announced. They then have struggled by posting steady declines for the next 100 to 160 trading days before finding a bottom and starting to rally. And although long-term U.S. Treasuries had generally outperformed during this latest QE phase, it was right around March 8 when long-term U.S. Treasuries established a bottom within this 100 to 160 trading day range and began to rally.

The key question looking ahead is whether we can expect long-term U.S. Treasuries to continue rallying as they did during QE2, or if they are instead likely to continue heading lower as they did during QE1.

A further rally appears more likely at this juncture for several reasons.

First, the ongoing sell off in long-term U.S. Treasuries during QE1 was driven in part by sentiment that the U.S. economy was poised to enter into a sustained economic recovery coming out of the financial crisis. This, of course, did not come to pass and the economic outlook is considerably more challenged and less optimistic at present, which is favorable for long-term U.S. Treasuries going forward.

Second, the stock market was still in the process of picking up speed to the upside after bouncing from oversold lows in 2009. Such is not the case today with stocks now trading at all time highs with fairly lofty valuations, putting the long-term sustainability of the current stock rally in question at this stage And since long-term U.S. Treasuries tend to rally during stock market declines, this also bodes well.

Lastly, capital markets were being flooded with new debt issuance from the U.S. Treasury during QE1 in 2009 and 2010, which is a stark contrast to today where new debt issuance from the U.S. Treasury is now declining in an environment where much of the long-term supply of debt is already locked up either with the Fed or foreign ownership. As a result, those that wish to purchase the remaining available long-term U.S. Treasury debt are likely to have to pay an increasingly higher price for it going forward given the increasingly dwindling available supply for purchase.

All of these forces suggest the greater potential for upside in long-term U.S. Treasuries in the months ahead, placing it more on the positive QE2 path than the challenged QE1 route.

Before closing, it should be noted that any allocations to long-term U.S. Treasuries should be viewed with a short-term to medium-term holding period in mind. The idea here is not to buy long-term U.S. Treasuries with the idea of holding them to maturity. Far from it. Instead, the design is to use these allocations to generate a positive short-term to medium-term price return while also hedging against a stock market decline and generating a reasonably attractive yield along the way in the process.

Thus, for those investors seeking a high quality hedge to their stock allocations, long-term U.S. Treasuries continue to represent an ideal way to establish such exposures. And the recent pullback in long-term U.S. Treasuries has provided a window of opportunity to establish such exposures at an attractive entry point. For those seeking such exposures with relatively less volatility, Build America Bonds (NYSEARCA:BAB) may also be worth a look in the same context.

Disclosure: I am long TLT, BAB. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Disclaimer: This post is for information purposes only. There are risks involved with investing including loss of principal. Gerring Wealth Management (GWM) makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by GWM. There is no guarantee that the goals of the strategies discussed by GWM will be met.