If you are actively trading, you can’t help but notice what happened during the last three trading days through November 12th.  Almost everything that was going up crashed.  Here are a few examples:

Gold, which closed in London at $841 on November 11th, dropped about 5%.  Gold stocks, which did not respond strongly to the gold run-up, plummeted.  For example, Seabridge Gold (SA), which had hit a high of $38.20 on Oct 26th (not in alignment with the high in gold), closed at $28 on November 12th.  That’s a plunge of 26.7% -- hitting 25% trailing stops.

High Tech flyers were equally hit.  Let’s look at Apple, Google, and Research in Motion:

• AAPL went from a high of $192.68 on November 7th to a low of $150.63 on November 12th.  That’s a fall of 21.8% in just a few trading days.
  
  
• GOOG went from a high of $747.24 on November 7th to a low of $626.21 on November 12th.  That’s a drop of 16.2%.
  
  
• RIMM went from a high of $137.01 on November 7th to a low of $100.01 on November 12th.  That’s a fall of 27%, which also hit trailing stops of 25% within a few days.

Gold stocks and high tech flyers would not seem to be correlated, but they have been.  So what else has been affected and why?  What about hot countries?

The Chinese stock market has been the hottest stock market in the world.  PGJ, which best reflects the Chinese market, went from a high of $38.85 on October 31st to a low of $30.18 on November 12th.  That’s a drop of 22.3%.  And one of the hottest Chinese stocks, China Mobil (CHL), went from a high of $104 on October 29th to a low of $80.49 on November 12th.  That’s a drop of 22.6%.

Even Brazil (EWZ), which has been one of the hottest countries, went from a high of $87.67 on November 8th to a low of $75.65 on November 12th.  That’s a drop of 13.7% in three trading days.

OK, so now we have drops in two of the strongest countries, gold and gold stocks, and high tech stocks.  What about other stocks that have been performing well but are not necessarily high flyers?  And, what about interest rate sensitive stocks?  NLY went from a high of $17.8 on October 29th to a low of $16.44 on November 12th.  While the drop is just over a dollar, it is still a 7.6% drop. 

So what’s going on?  You only have to go back a few months to figure it out.  From mid-July through mid-August we had a fall of about 10% in the global markets.  The media was screaming doom and gloom but the markets recovered.  And I believe the reason for the fall still exists.  It’s the global credit crunch from the sub-prime crisis.

Wall Street banks are facing the prospect of altering the valuations of their holdings due to the sub-prime crisis.  And this week, based upon new accounting rules, they might have to write down valuations as much as $500 billion.  This means Citigroup, Goldman Sachs, Morgan Stanley and other US banks are now compelled to decrease the value of their assets at market prices and take off huge writedowns.  

The new rule from the US Financial Accounting Standards Board - known as FASB regulation 157 - comes into effect on Thursday November 15th.  The new rule affects those assets that banks have been valuing according to their own in-house rules.  These are called “Level 3” assets.  The top six U.S. banks have $365 billion in such assets.  A Goldman Sachs spokesman said the rules had compelled them to place quality assets in the Level 3 category that are not at risk in any way.

What are these assets worth?  Well, right now there are $1.2 trillion in U.S. sub-prime mortgage securities. An index of such assets shows that the lowest grades of 2006 vintage debt are worthless, and BBB grades are down to just 18 cents on the dollar. AA grades are trading at around 60 cents, and AAA grades are near 85 cents.  These are probably much lower than they should be, but it just goes to show what happens in a crisis.  When you are in trouble, you can only unload your assets at firesale prices!

The world wide exposure to collateralized debt obligations is estimated to be about $3 trillion and all of it is in trouble.  Merrill Lynch has declared a 30% writedown on its holding of CDOs, offering a glimpse into the true values.  However, few international banks will admit to any losses on the scale suggested by market prices.  For example, UBS is booking its US mortgage debt at 90 cents on the dollar.

For many of these banks, their level 3 assets are much bigger than their tangible equity.  Here are just a few examples:

• Citigroup has $128b of assets in this category, or 205% of its tangible equity. 
• Morgan Stanley $88b (275% of tangible equity). 
• Goldman Sachs $72b (212% of tangible equity).  
• Lehman Brothers $35b (194% of tangible equity).

My guess is that the meltdown in global assets is a reflection of this crisis.  Banks are liquidating as much as they can to stave off a crisis.  Thus, everything is impacted, especially the best investments.  And the liquidation is causing other asset managers who see the sell off and then sell to protect their assets.  And at some point all that’s left is the people who buy and hold.  That’s fine if the sell off is only temporary as it was in July.  But what if it turns into the second major downleg of the secular bear market?  What will you do?

So What Does this Mean for Your Trading?

Nasty things happen during secular bear markets, such as the one we have been in since 2000, and you must be prepared for them.  The sub-prime crisis is just one example.  The sub-prime crisis will play itself out in mini-crashes like this one until it’s over or governments decide to bail out the big banks.  The latter, if it happens, will simply delay the impact of the crisis for a while.  As mentioned above we have a $1.2 trillion dollar problem here in the US, and a $3 trillion dollar problem worldwide, and that could have a major impact on global markets for some time to come.

If you are trading, you need to be aware of these factors.  If you are trading short term, you can simply profit from the money flows, but position trading in this market climate could be very dangerous.  And as the examples above show, even large 25% trailing stops will not necessarily be enough to protect you.  And do you really want your asset values to drop 25% or more?

Certain assets should be exempt from this crisis long term.  I would guess those to be tangible assets such as gold, silver and commodities.  However, outright ownership of these assets will protect you.  Leveraged ownership of these same assets could bankrupt you during the crisis because people will be selling off every form of asset that they can to protect themselves.

Will It End?

US mortgage companies are still doing sub-prime lending.  People with terrible credit scores can still get loans.  The only difference is that banks will probably not try to mask them as high-quality loans.  You’ll know what you’ve got with a sub-prime loan.

Until next week, this is Van Tharp.