The Second Leg Down

Chapter 7Strategies for Taking Advantage of a Market Drop

For investors who still have some dry powder, market drops can create opportunity. While overextended investors are scrambling to constrain losses or meet margin calls, others can selectively buy assets that have become oversold. Although mechanical value-buying can be susceptible to long periods of underperformance, other strategies can add value when markets appear “oversold”. In particular, we examine short-term contrarian strategies for equity indices and volatility-selling strategies with bounded risk. One theme of the chapter is that, when volatility gets sufficiently high, it may be profitable to swap long equity exposure with short volatility exposure.

THE ELASTIC BAND

It has been said that the most powerful force in financial markets is mean reversion. Mean reversion is the poor cousin of Maxwell's equations connecting electricity and magnetism or Newton's laws of motion, as there are no “laws” to speak of in finance. The rough idea is that an asset can't move far away from “fair value” or “equilibrium” indefinitely. Fundamental reality has to set in at some point. As the theory goes, the price of a stock can only overshoot for so long before value investors start to sell, based on unsustainable valuations. We can put this more precisely by looking at multiples, rather than raw prices.

Campbell and Shiller (1988) have created a financial ratio that continues to be followed closely. It is suitable for our current ...