25 Takes on 2007 Surprises, Part 1

4. "The Great Housing Depression of 2007." I just don't see it, not with 4.5% rates on 10-year yields and short-term interest rates getting cut at any sign of a more severe downturn in housing. Although, that said, I do somewhat agree with No. 5.

5. "Foreclosures steadily rise." I do believe that the subprime, BBB-rated category of homeowners is in trouble. These are people who have never been granted loans before and now they're getting mortgages at almost the same rate a herd of Bob Rubins would get them. However, these also are exactly the sort of people who don't have a huge effect on the economy one way or the other when they abandon their homes.

Kass says that the asset-backed securities, or ABS, market will be fractured by the volume of foreclosures at the subprime level. I've spent some time doing due diligence on very smart funds on both sides of this trade. I have no idea who is right(Nobel-level economists were doing the modeling on each side, so who am I to argue?). However, if the ABS market does start to fracture, enough hedge funds and banks are short the subprime tranche that a short squeeze would buffer any fall.

6. and 7. The hedge fund and derivatives industries. These are scary "surprises" worth pondering. If the subprime market falls apart, banks such as JPMorgan Chase(JPM Quote) could be exposed to trillions of dollars in counterparty risk. This is a doomsday scenario, and I know at least one multibillion-dollar hedge fund that told me it has taken out credit insurance on JPMorgan as a bet that this actually will happen. But there's a reason this type of insurance trades for pennies on the dollar: Most people believe this doomsday scenario is extremely unlikely. I'm in that camp.

8. Commodities. Kass says they'll collapse, and I agree that commodities will go down like they always do. Check out my column on the Madagascar Vanilla market to learn why.

9. Flat corporate profits. I just don't see how this is possible, given the extreme dollars that are going to be spewing at Microsoft(MSFT Quote) because of Vista and Exxon Mobil(XOM Quote) because oil is nonstop, and Google(GOOG Quote) because online advertising is going up another $6 billion and it'll be the main beneficiary -- just to name a few.

But this is a hard thing to model out with precision, and almost everyone I spoke to at the beginning of 2006 (you know who you are) was wrong about where we would be now in terms of corporate earnings.

10. Volatility rises exponentially. This one really interests me because the reality is, volatility confuses me. It's usually measured by the VIX indicator. In the 10 years I've been trading, the VIX has never been even remotely as low as it has been this year. And right now, this second, it's basically at an all-time low, or near it:

VIX Swings Low It hasn't been this low in a decade

Historically, this has been a mean-reverting indicator; in other words, when the VIX very high when compared with historical averages, it invariably comes down (as in 2001 and 2002) and when it's very low, it invariably goes higher. Very roughly, without going through the math on this, the VIX being at 10 right now means investors are assuming the markets are going to be almost flat over the next year with a very tiny range throughout the year.

This is almost certainly false; I agree with Kass that volatility will go up. We could even experience massive corrections along the way, since an increase in the VIX is usually associated with a decline in the market.

However, the VIX is so low that I don't know if we can really use any historical results to make a prediction here. After all, the markets and the VIX rose in tandem from 1995-99. And now more than ever before, hedge funds that use put-selling strategies have flooded billions into how this indicator is calculated, artificially lowering it. The VIX could go up, but I don't necessarily know if this will cause panic in the markets.