Long-Term Treasuries: How To Short The Stock Market With Greater Returns And Less Risk

 |  Includes: EDV, SH, TLH, TLT
by: Eric Parnell, CFA

Long-Term U.S. Treasuries continue to deliver exceptional results. And with chatter building about a potential short-term stock market top, now may be the time to buy.

At first glance, this sentiment might leave some scratching their heads. Taking a look at the 20+ Year U.S. Treasury iShares (NYSEARCA:TLT) as a measure for Long-Term U.S. Treasuries reveals little to get excited about. After peaking in early October, the category has essentially been trading sideways ever since. But this price action does not tell the whole story.

(Click charts to expand)

Click to enlarge

An important point to first highlight about Long-Term U.S. Treasuries is the price movement. When many hear Treasuries, they immediately envision a very stable and boring asset class that offers little risk and kicks off a coupon payment every now and then. This is certainly not the case when it comes to Long-Term U.S. Treasuries. To the contrary, these securities experience price swings that place it among ranks of a typical growth stock. In short, these securities move.

Now the following question often comes into play when considering Long-Term U.S. Treasuries. Do I really want to lend money to the U.S. government for up to 30 years at around 3%? The answer here is almost certainly not. And in many respects, the question itself misses the various price opportunities associated with these securities. For example, when investors own Apple (NASDAQ:AAPL) at 14x earnings or Amazon.com (NASDAQ:AMZN) at 136x earnings, are they ever asked whether it represents a good holding for the next 30 years? Of course not, because it is assumed that investors are likely to buy and sell these securities along the way. It is also recognized that some holders may have extremely short time horizons that may be as little as a few days or even intraday. The same principles apply when owning Long-Term U.S. Treasuries including TLT.

Where Long-Term U.S. Treasuries offer particular appeal in the current environment is their function in hedging against the stock market. From a higher-octane perspective, they continue to provide an ideal way to short the stock market. Here's why.

First, Long-Term U.S. Treasuries have repeatedly demonstrated the ability to rally sharply during periods when the stock market is in decline. And the returns generated from Long-Term U.S. Treasuries have often performed much better than simply just shorting the stock market.

The following is a breakdown of the price performance of the TLT versus a short position in the U.S. stock market as measured by the ProShares Short S&P 500 (NYSEARCA:SH) during the three major correction phases since the outbreak of the financial crisis.

We'll start by looking at the most recent episode from 2011. The stock market entered into a sharp correction not long after the Fed's QE2 stimulus program came to an end on June 30, 2011. This pullback continued for several months before finally bottoming in early October. Along the way, shorting the stock market provided a solid +18% return. But owning Long-Term U.S. Treasuries was far more rewarding. Not only did the TLT provide a more robust +30% return over this same time period, it came with monthly interest payments and the security of U.S. government backing.

Click to enlarge

This is not a recent phenomenon, as we saw the same returns differential play out during the stock market correction from April 2010, to August 2010. While shorting the stock market once again provided a solid +13% return, Long-Term U.S. Treasuries outperformed by a considerable margin with a +22% gain over the same time period.

Click to enlarge

Of course, instruments other than the TLT also exist that can provide exposure to the Long-Term U.S. Treasury market. For example, the 10-20 Year U.S. Treasury iShares (NYSEARCA:TLH) provides a way to still effectively short the stock market but with less price volatility, which implies less upside but also less downside. Conversely, the opportunity also exists to turn up the risk dial even further for those who want to short the stock market even more aggressively with U.S. Treasuries. For example, the Vanguard Extended Duration Treasury (NYSEARCA:EDV) is an exchange traded fund consisting of U.S. Treasury STRIPS that takes the effective duration all the way up to 27 years. In short, the EDV is a way to turn the volume on the trade all the way up to full blast. As the charts above demonstrate, positioning in the EDV has recently proven particularly rewarding when stocks have fallen into correction, gaining +55% during the 2011 pullback and +35% in the 2010 stock decline.

Click to enlarge
Click to enlarge

Thus, Long-Term U.S. Treasuries provide the potential for rewarding results on the upside when stocks fall into correction.

But what about the downside risk? This is where Long-Term U.S. Treasuries shine even more. A look at the performance of these instruments relative to simply shorting the stock market during rally phases reveals exactly why. Since the stock market bottomed in October 2011, a short position in the U.S. stock market has declined by a -21% through February 15, 2012. However, a position in the TLT over the same time period is down less than -4%. And even the high-octane EDV is down less than -8%. Both of these results from U.S. Treasuries are meaningfully better than the pure short stock allocation.

Click to enlarge

We witnessed similar results from Long-Term U.S. Treasuries during the past two stock market rally phases. While a pure short stock position would have been down over -25% from August 2010 to July 2011, the TLT was down less than -8% and the more aggressive EDV was down just over -16%. Highlighting the greater risk associated with the EDV, it should be noted that it tracked the SH to the downside for much of the early stages of the rally from August 2010, to March 2011, before finally diverging higher. Lastly, while a pure short stock declined like a stone by over -48% from March 2009, to April 2010, the TLT declined by just over -10% and the EDV by -21%.

Click to enlarge
Click to enlarge

Bottom Line

Long-Term U.S. Treasuries provide an ideal way to short the stock market in the current environment. Not only have they demonstrated the ability to provide greater upside than simply shorting the stock market during periods of equity declines, they have also shown the propensity to hold up considerably better than a pure short stock position during periods when equities are rallying. Greater upside with less downside is always an attractive proposition.

Before closing, it is worth highlighting an important point about this strategy. Using Long-Term U.S. Treasuries to short the stock market is an effective strategy in the current environment. But this does not imply at all that it will always be an effective strategy. For example, at some point in the future, pressures will begin to build that will force interest rates higher, which will likely mark the beginning of what could be a long and painful secular bear market for U.S. Treasuries. But this is an outcome that is still likely a few years off into the future. In the meantime, using Long-Term U.S. Treasuries to short the stock market is a highly effective strategy that is worth consideration.

Disclosure: I am long TLT, EDV.

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.