Thesis: While it is common for investors to prefer higher risk to augment returns in bullish markets, stocks do not always outperform bonds.
The U.S. stock market has been in a bull market for over five years now, rallying from 2009 lows after the Great Recession. The year 2015 has been no exception as stocks have rallied even in the face of a rising U.S. dollar. A weak dollar makes equities look more appealing to increase returns as stock prices are denoted by the dollar, so they have an inverse relationship. The U.S. dollar has seen its largest price rally in a long time as it has rallied over 21.8% in the past 10 months. This odd rally is considered a black swan – an event that is highly unlikely to occur and is multiple standard deviations away from the norm. Black swan events make it possible for unusual returns for investors, kinda like Treasury bills outperforming stocks in a bull market. Treasury bills are considered a safety net, and investors flock to purchase them in times of strife or market decline as they provide a safe, guaranteed return.
In a recent article by the Wall Street Journal titled, “Buying U.S. Currencies with Foreign Denoted Currencies Pays Off,” many trades are highlighted that outperform the U.S. stock market as defined by the returns of the S&P 500. The most profitable trade is buying U.S. 10 year treasuries with the Euro. While the U.S. dollar has prospered, the Euro has had a dramatic decline due to financial turmoil in the region. The article does a good job explaining the unlikelihood of the trade, “Thanks to a roaring dollar rally and a world-wide grab for ultrasafe government bonds, one of the keenest bets in financial markets over the past year has been one that isn’t typically associated with outsize returns: buying U.S. Treasury debt with foreign currencies.” What is even more shocking is the returns that some of these trades have fetched, especially compared to the benchmark index during such a prosperous time. “Investors buying Treasury debt in euros earned a total return of 36.7% over the past 12 months, reflecting price gains and interest payments, according to Barclays PLC. The same investment would have earned 23.9% in Japanese yen, 19.8% in British pounds and 16.9% in Swiss francs.” So not only do the returns either rival or top the benchmark index, but they also carry much less inherent risk. Alpha investors seeking to mimic returns while taking on less risk would be delighted with such returns. For an elaborated definition of alpha, check out Investopedia on the topic. Alpha has become increasingly popular amongst hedge funds, and this trade highlights some of the successes to the strategy.