For both natural and financial disasters, extreme preparation supersedes precise predictions. These are difficult days for value investors. There is a paucity of opportunities offering anything close to a margin of safety capable of sustaining long-term gains. Nearly all metrics agree. Whether you use CAPE, price-to-sales, GDP-to-market cap, or many any other measures, today’s market is dangerously detached from its underlying fundamentals.
Further, volatility of the S&P 500—historic and the VIX—has been so calm for such a prolonged period of time, despite the demonstrably more chaotic political and environmental climates, you could be forgiven for thinking the world was now segmented into distinctly disconnected parallel universes. I believe that economic and market stability is an illusion, a prelude to less tranquil conditions.
I have already discussed the benefits of holding outsized liquidity through such periods. The advantage derives not just from avoiding losses, but even more from the optionality it provides—the ability to purchase equities at bargain prices when panic returns to the market.
Opportunistic value investors have more options than simply waiting for expensive markets to regain their senses, though. While the timing is unpredictable, I still believe in mean reversion—the central tendency of all things. When fear and panic subside at the end of bear markets, stock prices rise. The opposite occurs when bull markets run their inevitable course. In anticipation of falling prices, put options offer value with defined risk. No matter how much the market may rise after you have purchased the options, the premium paid is the most you can lose—limited risk, with the potential for significant gain.
This is a particularly attractive move today because premiums are currently so low. The Chicago Board Options Exchange (CBOE) volatility index (VIX) recently saw lows just under 10, a number last seen in the early months of 2007. Colloquially known as the “fear gauge,” it spiked repeatedly during the turbulence leading up to the 2008 crash and hit 80% during the darkest days of the financial crisis. The positive correlation between the VIX and “implied volatility,” a key valuation component of option returns, is the means to transforming today’s bargain premiums into the “significant gain.”