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It appears that the Post QE2 stock correction is now underway. Unlike with QE1 last year when investors stayed in the stock market until the very end of the Fed’s balance sheet expansion, it seems that investors are anticipating the end of QE2 on June 30 in advance and are already moving to the exits. If you are anticipating that the stock market may continue to correct as we move through the summer, the question then becomes how to best capitalize on this trend. U.S. Treasuries provide a straightforward and relatively low risk way to capitalize on a declining stock market.

If you believe the stock market is heading lower, the most obvious investment position to undertake is to short the stock market. This could be accomplished in a variety of ways. Leading among these is selling short a major market ETF like the SPDR S&P 500 (NYSEARCA:SPY) or going long an inverse ETF like the ProShares Short S&P 500 (NYSEARCA:SH). Both of these options provide a perfectly negative correlation of -1.00 to the S&P 500 Index and would provide full exposure to an expected market decline.

Although such approaches are certainly straightforward, a few problems may make these options unsuitable for many investors. First, many investors may not be comfortable with the idea of taking on a short position and its potential for losses that exceed the initial investment. And in some instances, investment managers may be overseeing a mandate that restricts against short selling. Second, going long an inverse ETF as an alternative to shorting results in performance leakage problems the longer the position is held.

But just as important a problem are the additional “qualitative” risks that exist in today’s investment marketplace. Since the financial crisis, the government including the U.S. Federal Reserve has been heavily involved in investment markets. And much of the movement in markets since the March 2009 bottom could be heavily attributed to the actions of the Fed. Unfortunately, it can become difficult to quantify what a person might decide to do on any given day. This includes what a Fed Chairman might wake up and decide to do or say at any point in time. As a result, investors may be reluctant to go “all in” on an equity short position recognizing that the Fed could just show up one day and start sending signals that QE3 is soon on its way, which could subsequently result in a sharp stock rally that may be completely unsupported by the underlying data at the time.

Fortunately, the U.S. Treasury market provides an ideal way to essentially get short the stock market with a naturally imbedded hedge against such sudden and unexpected events. Conducting a performance comparison of the S&P 500 Index and the iShares Barclays +20 Year Treasury Bond Fund (NYSEARCA:TLT) since the October 2007 market peak demonstrates this opportunity.

Overall, the beta for TLT relative to the S&P 500 Index is a -0.62, which implies that when the stock market is down -1%, the TLT will be up +0.62% all else being held equal. This implies that the TLT will likely experience less volatile price swings relative to the stock market, which is favorable from a risk control perspective. The TLT also has a correlation of -0.38. While this is not a perfectly negative correlation, it is still meaningfully negative, which implies the opportunity to generate gains when stocks are in decline. In addition, it is worthwhile to evaluate under what circumstances correlations moved in the same direction.

A graphical look at the S&P 500 Index versus the U.S. Treasury market as measured by the TLT sheds more light on this inverse relationship (click to enlarge). Essentially, when the stock market entered into correction, the TLT rallied. And the sharper stocks declined, the more pronounced the rise in the TLT. Conversely, when stocks entered into rally mode, the TLT did not always enter into decline. And when the TLT did pull back, it was to a magnitude that was less than the associated rise in stocks. In short, Treasuries have been working in favor of investors during stock market corrections but have not been working against investors to nearly the same degree during stock market rallies.

This is where the TLT’s lower negative correlation works in favor of an investor seeking to use the TLT to essentially get short the stock market. Of course, this assumes this relationship continues to hold into the future, but there is certainly no indication at present that this relationship is set to break down any time soon.

Beyond using U.S. Treasuries to effectively short the stock market, they also provide the additional benefit of generating income for investors. In addition, U.S. Treasuries are still a safe haven for investors seeking to protect their principal during periods of crisis or uncertainty.

Trading Strategy

Investors seeking to position for a stock market decline can do so by getting long U.S. Treasury ETFs like the TLT discussed in this article. It should be noted that the TLT is the most aggressive of the Treasury ETF options available. For those investors that are seeking an even less volatile option to effectively short the stock market, the iShares Barclays 7-10 Year Treasury Bond Fund (NYSEARCA:IEF) or the even more conservative iShares Barclays 3-7 Year Treasury Bond Fund (NYSEARCA:IEI) are also suitable alternatives.

Disclosure: I am long TLT, IEF, IEI.

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.

Source: Treasuries: A Safer Way to Short the Stock Market