Macro: Sandcastle economics
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Lessons from 2008 on how to navigate equities in high volatility
Peter Garnry
Chief Investment Strategist
Summary: In today's equity update we show today's performance of our 'bounce back basket' what we published yesterday as we told investors to prepare for a reversal in equities. With volatility to stay for a while equities will exhibit a lot of mean-reversion. We show how well mean-reversion strategies performed in 2008 and highlight how investors can construct mean-reversion strategies.
One thing is our ‘bounce back basket’ but what can investors and traders learn from the 2008 trading environment to navigate the current environment? With the VIX Index close to 50 equity markets remain in an extreme volatile environment and historically this has meant more volatility (also as the volatility clustering effect) and returns skewed to the downside.
But even more important high volatility often fuels mean reversion in equities which means that large down days are followed by large up days just as we are observing over the past two trading sessions. In low volatility markets momentum dominates and everything in between has less structure. Mean reversion is structurally driven by volatility and provides investors with an opportunity to become more tactically. In fact we would argue that as volatility increases investors should be less long-term and more short-term. By applying mean reversion tactics investors can add a vital return stream to the portfolio. But how should mean reversion be implemented?
There are several ways. The simple one is to short the stocks that did the best yesterday and buy the stocks that did the worst. As some sectors often lead the gains and declines one should consider not shorting and buying from the same sector. Another way to structure mean reversion is using technical indicators such as Bollinger Bands and RSI selling and buying when these indicators have high and low values respectively. The idea in mean reversion strategies to keep the volatility low is to both buy and sell which is best done on Saxo’s trading platforms through CFDs.
As the plot from FactorResearch shows mean-reversion was a key strategy to any portfolio during 2008. Evidence also suggest that mean-reversion strategies work best when the VIX Index is above the 22 level which is considered to be the long-term equilibrium in the volatility term structure (forward curve). As the oil price war between Russia and Saudi Arabia combined with COVID-19 will likely fuel elevated volatility for some time we will begin regularly to publish inspirational lists to help investors construct these mean-reversion strategies.
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