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It's hard out there for a stock market bear.

One might scan the current market and come to the conclusion that now is a good time to short the stock market. After all, we've seen a +20% rise in stocks from the early October lows, yet conditions in Europe have gotten worse, not better. While the U.S. economy has certainly picked up some steam in recent months, corporate profit margins remain at record highs and the pace of the recovery remains sluggish and at risk of slowing anew in the coming months. And despite these challenges, the AAII Investor Sentiment Survey is now signaling that a remarkably low 17% of all investors are currently bearish. In a normal market environment, these signals would certainly suggest the potential for a meaningful downside pullback in stocks as we move forward into the coming weeks.

Despite these warning signs, the prospects for shorting the stock market remain highly treacherous. This is due to the persistent presence of policy risk. While it might look sensible to short the stock market at certain points in time, there is simply no way of knowing what policy actions a leader of a global central bank in the United States, Europe or China might decide over their Cheerios on any given morning to carry out that will jolt the stock market into a heightened state of euphoria. And such policy risk leaves the investor who is short the market with the potential of having their shirt abruptly ripped off their back at any given moment.

Thus, it is worthwhile to consider alternative methods that one might apply to effectively get short the stock market while at the same time mitigating the sudden sharp downside risk. Fortunately, the long-term U.S. Treasury market provides a high quality and sensible way to effectively short the stock market with less risk.

Beyond purchasing individual U.S. Treasury positions, two particular securities also enable investors to quickly establish what is effectively a short position to stocks via the long-term U.S. Treasury markets.

The first is the iShares Barclays +20 Year Treasury Bond ETF (NYSEARCA:TLT). This holds a basket of nominal U.S. Treasuries that have an average weighted maturity of over 28 years and an effective duration of 16.87 years. It provides a monthly yield that is currently in the 3% range and has a negative correlation of -0.46 to the U.S. stock market as measured by the S&P 500 Index.

The second is the Vanguard Extended Duration Treasury ETF (NYSEARCA:EDV). This holds a basket of U.S. Treasury STRIPS, which are zero coupon U.S. Treasuries that trade at a discount to par. The EDV has an average maturity of over 25 years and an effective duration of 26.9 years. And unlike owning STRIPS directly, the EDV pays an annual yield of nearly 3% on a quarterly basis. It has a negative correlation of -0.48 to the U.S. stock market and has a beta that is roughly 2x that of the TLT. In other words, the EDV provides a more aggressive way to short the stock market using the U.S. Treasury market than the TLT.

Before going any further, it should be noted that the long-term U.S. Treasury market including both the TLT and the EDV are not the quiet and steady investments that some might expect to be associated with the U.S. Treasury market. To the contrary, this is a high-risk investment category that offers the potential for outsized returns but is accompanied with meaningful price volatility. As a result, such positions are not necessarily suited for risk-averse investors to hold in isolation and must be managed strategically with a broader portfolio context in such cases.

The following chart from January 2008 to the present highlights the inverse relationship between long-term U.S. Treasuries and stocks.

Click to enlarge:

The green and orange lines show the returns performance of the TLT and EDV, respectively. The black line shows the returns performance of the S&P 500 Index on an inverted scale shown on the right axis. Several appealing elements stand out in the relationship between long-term U.S. Treasuries and stocks:

First, when stocks fall into a sharp decline, long-term U.S. Treasuries rally sharply with a very high correlation. And in many instances, the strength of the Treasury rally often exceeds the magnitude of the decline in stocks.

Second, when stocks bottom and begin to move higher, long-term U.S. Treasuries will typically stabilize following an initial decline even if the stock market continues to rise. This helps limit the downside associated with holding such positions.

Lastly, when the correlation breaks down between stocks and long-term U.S. Treasuries, it is typically to the advantage of long-term U.S. Treasuries. For example, while stocks have drifted sideways since the summer of 2011, long-term U.S. Treasuries have exploded to the upside. This suggests the potential for upside in these securities even if the stock market remains stuck in a holding pattern. Taking this most recent relationship one step further, it also raises a question as to what the U.S. Treasury market might be signaling about the stock outlook in the months ahead.

Thus, for those investors seeking to either get short the stock market or to secure a hedge in their portfolio against a sharp decline in stocks, the long-term U.S. Treasury market may provide a sensible, high quality way to establish such exposures.

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: Long-Term U.S. Treasuries: A Sensible Way To Short The Stock Market