Wait for The Hunt for the Red October

While the Asian market was on the verge of breakdown, the Dow Jones Industrial Average (DJIA) continued to hold up and made a new year-to-date high last Friday as if recession never occurred. The Dow Jones went up 185 points and closed at 9,505 last week, reversing the 200 point drop earlier on Monday. On the other hand, the Shanghai Stock Exchange Composite (SSEC) was in trouble and closed at 2960, struggling to get back above the 3,000 level.

Does anyone remember the term “decoupling”? As we all know, the analysts always love to invent some uncreative new phrases that have same old meanings. Few years ago, some analysts projected that the Asian stock markets, especially the Shanghai Stock Exchange Composite in China and the Hang Seng Index in Hong Kong, are going to not only outperform but also no longer under the influence of the American stock market. In other words, the Asian markets would be immune from the decline of the American indices. This phenomenon is known as “decoupling” since the stock market movements in the East and West are no longer correlated. But after March 2008, nobody talks about “decoupling” anymore when all the stock markets in the world all tanked in sync.

But the analysts always feel obliged to invent new terms. This time they have invented a term called “China Syndrome.” As mentioned in most recent financial reports both in the press and on the web, this term refers to the negative effect of the Chinese market on the global markets. If China tanks, the rest of the stock markets in the world are also going to tank.

This “China Syndrome” phenomenon is indeed valid --- for one day only. The DJIA fell more than 200 points last Monday and most analysts blamed on the precipitous fall of the SSEC from China, which fell from 3,500 to as low as 2,760 in the last three weeks. While most stock investors were about to point their fingers at the Chinese, the DJIA made a U-turn and went up again for the rest of the week. All of a sudden, the “China Syndrome” disappeared.

And let me make a following prediction: The word “Greens Shoots” will disappear as early as March 2010. Most professionals, such as the economists who often make wrong predictions and the fund managers who often make wrong decisions alike, have claimed that the economy is getting better. They used different jargons and numbers to explain their reasons but basically they all have the same conclusion --- things just can’t get any worse.

I am not a professional economist nor am I a fund manager (although I do wish to become the latter one if my destiny permits), I do believe in something called history. If you search online and look at the history of Dow Jones, you’ll that a bull market usually lasts for about 5 to 7 years while a bear market about 3 to 5 years on average. But if we look at Japan, their Nikkei Index started falling in 1990 and still cannot claw back to the previous high 19 years ago as of today. Strictly speaking, Japan has suffered a bear market that has lasted for 19 years!

If we count October 2007 as the beginning of a bear market when Dow Jones fell from 14,198 and claim that the calamity was over when the index hit 6,647 in March 2009, does it mean that this bear market lasted only for 15 months? Do you believe, really believe, the financial crisis that started 10 years ago, resulting in the fall of Merrill Lynch, Bear Sterns and Lehman Brothers and millions of people losing their homes and jobs, could all be resolved in only 15 months? Do you think the crisis is now over?

As I said before in my column, the Wall Street is still propping up the market and tries hard to lure more capital in the stock market, creating an illusion that the economy is getting better. I don’t know how long the Wall Street will sustain the rally but I am very uncomfortable with the low volumes and the relatively high put/call ratios during the rally. Think about it: Why do people still buy put options if they are going to hold their long positions for a long time?

I think, totally out of my intuition, the current rally is mainly participated by sophisticated investors, such as the traders of the investment banks or the hedge fund managers, who still want to lure individual investors to the stock markets.

Why do they prop up the market now? Why don’t they play the short side? Let’s say they are going to short the Dow Jones Industrial Average now. What is their maximum profit? The current 9,506 point worth of future contracts, right? It is because the stock index cannot go below zero. But if they can prop all the way up to 10,000 or higher, they can win by shorting 10,000 point worth of future contracts and bank home with more money. And who is going to pay for it? The individual investors who are going to pay up for the stocks they sell.

Based on the current extreme overbought condition, I do expect a serious duel between the bulls and the bears some time in September or October. Perhaps I may be wrong. Maybe it is indeed the beginning of bull market. However, I will stay away from the storm for now. If you believe the stock market will go down and turn red again, I think September or October is ripe to play for the short side. Let’s wait for the Red September or October.