Friday, August 27, 2010

Volatile and Risky Market

The equity stock market has a strong rebound today after a long decline. It is still unknown whether it will continue to drop again next week. The portfolio is holding a long position and the value fell to only two third of the year maximum yesterday.

Individual stocks in portfolio exhibit weakness relative to the broad market. The market finished with gain on Wednesday. It is hoped for an extended rebound after a long decline. With heavy borrowing from account purchasing power, a relatively large position in leveraged ETF is added to the portfolio. Unfortunately, the rebound cannot sustain in such market condition. This investment decision is a bet on the stock market. Although general sentiment is pessimistic, there is no significant selling pressure. Since there is hedging to reduce the loss, the position is held overnight for the play.

In the beginning of the trading session, the encouraging GDP figure moves up the market slightly but then suddenly it drops below yesterday's close. It seems to continue the downward trend in this month. But then it suddenly reverses and sharply moves up. In the last few days, the market is very volatile and moves violently. The market finally ends highest of the day. The portfolio holds the newly added ETF position and corresponding hedging until end of the day. If not for the hedging, the gain would be much higher. However hedging provides sense of protection in such volatile environment though at a cost. Without hedging, it may be scared not to hold the position overnight with such heavy borrowing. It would be devastating if the market moves against the portfolio as experienced during the financial crisis.

Although the bet in this investment returns a profit, it is a very risky decision with 50% chance of win or lose. The portfolio needs to be reorganised to better handle the market volatility and to grasp opportunity to make profit. It is now still exploring the trading strategy by means of trial and error. Since the portfolio has a core position for bull market, the overall portfolio value is declining recently. The downward trend in the equity market during the past few months shrinks the portfolio value. It is not known whether the trend will continue downward or already reach the bottom. The longer term holding positions in the portfolio will be reviewed for a smaller proportion of the portfolio. Holding an investment has a market risk although buy and hold strategy probably works in long term. Day trading or trades spanning across only a few days can minimize market risk but it is exposed to randomness.

As discussed in previous posts, investors (corporate and individual) are reluctant to enter the market at current level. They are waiting on the sideline for a low market entry point. The scenario is not the same as the economic depression starting in 1929. The advance in technology has created significant wealth compared with that time. Thus the impact of an economic cycle on the average person is less severe. However, there is a shift in the economic structure in the global environment. Due to the lower labor cost and improving competitiveness in developing countries, there is a growing trend for outsourcing of jobs from developed countries. Coupled with the trough of an economic cycle which is triggered by the financial crisis, the financial market collapses and hit the economy. The recession/depression will recover as usual in an economic cycle. However, the structural change in labor market has unprecedented impact on the society. The intertwined relationship of economic cycle and structural shift in labor causes the violent movement in financial market.

Many individual investors have not fully recovered the confidence since the financial crisis. While waiting, their wealth are moved towards bonds and treasuries which are providing a yield though relatively small. Some are moved towards commodities which do not provide yield but are considered safe relative to stock equity. Stocks can provide the best return but are considered risky at current level. Therefore capital does not flow into the equity market until it drops to an attractive entry point. On the other hand, the potential return of stock equity attracts some risk taker for short term profit as well as some bargain buyer for long term appreciation. Thus the trading volume is low and there is no panic selling or buying. But there is still volatility because market maker can easily move the market because there is less participants.

There is unlikely any panic sell-off to drive the market down significantly to a level that is attractive to the investors who allocate their wealth mainly to bonds and treasuries. The stock equity market will probably drift around and will continue to trade at low volume until a trigger for the enthusiasm of the investors waiting on the sideline. The wealth effect of equity appreciation will then drive the market to a level corresponding to risk and return.

Although current stock equity appears attractive based on valuation, there is not much driving force for upward price movement. Therefore the trading strategy will still be optimistic but will be aware of potential downfall due to market news or rumors.

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