Deleveraging As a Strategy - Review and History

I forgot to mention in my last post that there is another profit component to a successful deleveraging strategy. Not only do you make a profit from the interest of the loan, but if the recession is broad based (as it is in this economy) we again experience the flight to quality with people dumping risky high beta asset classes (stocks) and start moving into safer assets (US Gov Bonds).

When you go short stocks and long bonds to deleverage, if what you predict becomes true, you'll also make a profit when capital rushes from one asset class to another. With demands for bonds rising, the yields will fall and prices will rise so your bond will become more valuable also (capital appreciation).

We may remember Warren Buffet's notoriously correct (but poorly timed) shorting of tech stocks. Although he was right, he lost a lot of money leading up to the burst of the bubble by employing this strategy.

With this historical perspective in mind (of a seasoned investor making a similar gamble) I would presume that a strategy that utilizes this technique probably has an incredibly high Sharpe ratio and at the end of the day probably isn't worth it. It requires too much foresight and insight into behavioural finance which, if the recent economic problems are any indication, might as well be black magic. Dealing with derivatives is hard enough. Dealing with derivatives that depend on emotional factors and exhuberance is crazy.