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How to make sure YOU don't own the next Bear Stearns

By Chris Rowe March 31, 2008 Facebook Logo Twitter Logo Email Logo LinkedIn Logo

Let me tell you what's really going on in hedge fund land that you should definitely think about when stepping onto the battle field this quarter.

Last Week, Lehman Brothers Holdings' (SYM: LEH) stock dropped 10% on a false rumor that they had liquidity problems similar to that of Bear Stearns (SYM: BSC).

This rumor was allegedly spread by hedge funds in an attempt to profit from short selling of the stock. Unfortunately, this type of thing happens all the time, but rarely gets picked up by the authorities or the media.

Instead, the stock just gets hammered, and only a few institutions really know why.  Manipulation of some kind will always be part of the stock market, so there's no use in grinding our teeth and shaking our fists about it.  Instead, just profit from it (with bearish trades on overbought Wall Street stocks), or steer clear of the most likely future victims.

One might argue that Wall Street stocks have been so beaten down that if you were to buy here, for the long-term, you'll come out on top.  Theoretically, that might be so.  But staying long an unhedged position in Wall Street stocks is like standing next to a guy who the mafia just put a contracted hit on.

Let me explain just a bit more than the obvious...

Wall Street stocks are easy prey right now, and you'd better believe the bearish hedge funds are capitalizing on it.  Hedge funds are well known for paying millions of dollars for inside information, or to create positive or negative sentiment.  This practice became much easier in July of 2007.

You might have heard about the "uptick rule" being abolished last July (although it barely got any press).  Long story short,  in order to prevent an institution's ability to manipulate a stock's price lower by applying continuous selling pressure to a stock, the SEC created the "uptick rule".

The rule dictated that you couldn't sell-short a stock until the stock traded at a price that was above the last traded price.

In short, the abolishment of this rule gave institutions the power to "lean" on a stock's price, thus triggering other investor's automatic sell orders. This leads the way to massive panic selling, which can cause a stock to drop at a much faster rate.

If you hear a rumor that you own the next Bear Stearns, and you notice the stock is down 10% and dropping through a major support level on heavy volume, you wouldn't be foolish for selling.  But remember, the stock may not have broken support if not for the ability of the big institutions to knock it down to levels that would surely cause even more selling.

It Gets Worse

There's another important part to this story that I never hear the media talking about.  Rules on margin requirements are changing, making it easier for funds to use more leverage. Another long story short (hee-hee)...

As of April 2007, new rules allow brokers to base margin requirements on the overall calculated risk of a portfolio instead of calculating it for each security within a portfolio.  What do I mean by overall risk?

Margin accounts used to require that 50% of the value of a position must be put up.  If an institution wanted to buy (to make math simple) 100,000 shares of a $100.00 stock, the margin requirement used to be $5 million (50% of the $10 million stock position).

But if the institution also purchased protective put options that gave the fund the right to sell that stock at $100.00, the risk would be the cost of the put options.

This is because the put options allow the investor to sell the stock at $100.00.  The put option acts as an insurance policy, protecting from a disastrous decline.  The maximum risk then becomes the price of the protective put.

To protect that $10 million dollar position, a put option position large enough to insure that $10 million position, if trading at $3.00, would cost $300,000.00.

Institutions can control $10 million worth of stock for a cash outlay of $300,000.00.  So, instead of a 2-1 margin ratio, you're looking at a 33-1 margin ratio.  Institutions, in this example, need 3% of the value of the position instead of 50%.

So a few months before abolishing the "uptick rule", thus making it much easier for institutions to literally manipulate a stock lower so long as they had the buying power to do so, they changed margin rules to give institutions 17 times the buying power (or short-selling power) they used to have!  WOW! SCARY!

According to Dorsey Wright and Associates, "S&P 500 volatility as measured by daily changes of at least 1% now stands at a 70 year high. Since the bear-market turnaround in 2002, the number of significant daily market moves has gone down from 49.6% to 11.6% in 2006, and was 12.9% for the first half of 2007. Then, with the emergence of the credit uncertainty, market volatility shot up to 38.6% for the second half of 2007 and now stands at 51.9% for 2008 - a level not seen since 1938."

Let's bring it back to the discussion about stocks in the Wall Street sector.  I said that Lehman Brothers tanked 10% on a false rumor of liquidity issues; a rumor apparently spread by hedge-funds. The 10% drop is circled in blue.

(Gosh, can you believe how shameless that is!  Manipulating a run on the bank!)  That was nothing compared to the 60% decline in the stock one trading day after Bear Stearns went to $2.00.  Obviously investors are quick to dump these stocks.

That rumor is being investigated, so the heat is on for the moment.  But over the next couple of quarters, the heat will die down and the easiest prey, when it comes to manipulatable stocks, continue to be the Wall Street stocks.

We haven't heard the last of the hedge fund troubles caused by this credit crisis.  JP Morgan (SYM: JPM) wouldn't have even announced a bid for Bear Stearns for $2.00/share unless the Fed backed the deal up.  Do you think after something like that everything is cool with the Wall Street sector?

Even if the sector, by some miracle, is perfectly fine - even undervalued - investors will sell at the drop of a hat when they hear more news.  And you'd better believe there are smart hedge funds that are making a killing betting against the sector.  Forget spreading rumors.  These guys can easily manipulate stocks with the new margin rules in place, and the old protective uptick rule out of the way.

The message today is to leave these stocks alone, and if you are in them for the long term, you might want to hedge the positions.

I know what some of you are thinking.  What goes down must come up.  If you short a gazillion shares of a stock like Lehman Brothers, you eventually have to close out the position by buying back the gazillion shares causing a "short-squeeze."  I wouldn't do it folks.  Buying on the dips of a down trend tends to be a losers game.  Not because you can't make money doing so, but because there are bets out there with much higher reward/risk ratios.

I will be providing members of The Trend Rider with ideas of that nature.  (Had to add a bit of shameless marketing to my article.)  I hope to see you there.

(Don't forget to comment on my idea to provide you with free bi-weekly, market summary videos.)

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