My field study in China produced more than a handful interesting subjects I'd like to write about. Unfortunately, the Blogger hosting server is blocked for access in China and I will have to find time in the coming weeks to finish my writing backlog.
In mid January, I started becoming concerned about the market excess of the near term. The speed and rate of recovery from the 02/27 "mini-crash" were extraordinary: not only the market regained its loss within a few weeks, but the upward trend accelerated, indicating extraordinary confidence among market participants. The mass mentality was also reflected in the VIX index, which returned to its historic lows in late March, lasting through May. Because of such low volatility, people were adding ever more leverages to their holdings to pursue a bit of extra yield. But one thing that people often forget about is that low volatility does not equal to low risk.
That prompted me to write about such Irrational Complacency. In a nutshell, the investment thesis is to buy volatility for the near term. The most direct way to express this is to long the VIX spot. However, there's no such an instrument available. The VIX futures are difficult to use because of the timing involved. So at the end of May, I did the next best thing I knew: sold all financial related holdings including REITs, and then short the S&P 500 with leverage. The S&P 500 is known for heavily weighted on financial stocks. Besides taking a sector-related directional position, the other objective is to hedge the remaining non-financial holdings, which correlate to the market index, but in a lesser degree. At the time, the S&P 500 was around 1520 and just kept going higher.
Was it painful to watch the instant loss after putting on such a trade? Not really, because the thesis remained the same. That made me at ease to take an extended time-off from the market. It's also refreshing to think from a distance of the daily market fluctuations, and taking the time to study the detached capital markets in China.
Since mid July, the VIX index have doubled, even tripled at the peak. And the market has turned from a 9.7% gain to a merely 1.1%, sometimes reaching the negative territory. Many investors became worried, and bargain hunters had some great time, pushing the market higher twice between July and August. Does this mean it's time to go bottom fishing? An overbought market can be more overbought; an oversold market can be more oversold. I would like to see the market consolidates around the current range (1400-1450) for a while before considering a reversal.
Also as mentioned in my previous posts, I think that the Fed is more likely to hike the Fed fund rate than cutting it, and many on the Wall Street disagree. My current estimate is that it could reach 6% by mid 2008, further drying up the liquidity and pushing up the mortgage rates. The crash in housing price has not really started.