Daily Form August 10, 2007

Profit Patterns and Risk Management For Active Traders
Trade successfully without having to be right about the underlying market direction
FRIDAY AUGUST 10, 2007       07:11 ET

There was no shortage of dramatic looking charts as I scanned through the outcome of yesterday’s panic stricken session. Many of the charts for individual stocks showed some extraordinary moves with many institutional favorites revealing the kind of drops that are not normally seen except in liquidity crises. Of the six hundred stocks that I monitor ninety two of them showed drops of more than five percent. Amongst the casualties were several of the financial stocks that have been discussed here on several occasions. Principal Financial Group (PFG) dropped back by almost seven percent, Lehman Bros (LEH) dropped by more than seven percent and Goldman Sachs (GS) fell by more than five percent. But there were many other signficant casualties from beyond the obviously troubled financial services sector suggesting that indiscriminate selling was behind some of the larger moves.

There is no doubt that financial contagion can produce what are sometimes called correlation liquidity crises and we seem to be immersed in one at the moment. (These kinds of liquidity crisis are the subject matter of the last chapter of Long/Short Market Dynamics).

In these circumstances market behavior is qualitatively different from the more "normal" circumstances of daily trading. Correlations amongst asset classes increases dangerously and many market participants are forced to sell those assets where there is a bid as opposed to those assets that they would like to bale out from but where there is no bid.

Certainly one of the more striking charts is for the CBOE Volatility Index (^VIX) which moved above 26 yesterday and which is the highest level since the latter part of 2002 and early 2003. The way that the index is behaving is highly reminiscent of previous liquidity meltdowns such as the LTCM crisis in August 1998.

The S&P 500 (^SPC) dropped by three percent and after tagging the 50 day EMA in Wednesday’s trading it has returned in a hurry back down to the 200 day EMA.

The investment banks are trading below the levels seen in March when the sub-prime mess first manifested itself to non specialist market participants. The real problems that have arisen for the large players in the credit derivatives markets extend beyond the fact that one sector of the mortgage market is seeing a large increase in delinquencies and defaults. The problem is well revealed in the remarks from BNP Paribas in yesterday’s announcement that they cannot provide a valuation of the CDO’s that they have in some of their funds. This came after the bank had reassured markets just a week or so ago that they had were not seriously exposed to fall out from the sub-prime sector.

Their inability to place any kind of robust valuation on their holdings of structured debt products highlights the real scare that is facing financial intermediaries i.e. there is no reliable and robust methodology for marking their holdings to the market when liqudity evaporates.

The financial engineers that have devised these complex debt instruments may have models which claim to precisely assess the values of these "assets" to five decimal places but if there is no bid for them then what are they actually worth?

Perhaps most alarming of all is the prospect that the reason why there are no bids for many distressed derivatives is that they are either not properly understood by a lot of bank/hedge fund principals or that those that do understand them have sensed that they were structured on bogus premises about risk probabilities and market liquidity.

The Nikkei 225 (^N225) has come down to a critical level in overnight trading. It finished off the lows for the session but a break below 16600 could create a new avalanche of selling.


The patterns identified below should be considered as indicative of eventual price direction in forthcoming trading sessions. None of these setups should be seen as specifically opportune for the current trading session.
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GS  The Goldman Sachs Group Inc.  

After seeming as though it might stabilize at the level of the March lows, Goldman Sachs (GS) continued down by 5.7% yesterday as rumours circulated that it was liquidating a major long/short equity fund under duress.

NOC  Northrop Grumman Corporation  

Although in percentage terms it was not a major mover, Northrop Grumman’s drop (NOC) brought it decisively below a major trend line.

ONNN  ON Semiconductor Corp  

The chart for ON Semiconductor (ONNN) reveals a a rather notable failure following the surge and opening gap upwards move on very heavy volume from late July.

OI  Owens-Illinois Inc.  

Owens Illinois (OI) acted very poorly in yesterday’s session and as the MFI chart clearly reveals this stock was under distribution during the recent period of new nominal price highs.

OSG  Overseas Shipholding Group Inc.  

Overseas Shipholding Group (OSG) was another institutional favorite that came down hard yesterday as it lost more than seven percent. Looking at the support/resistance levels revealed on the chart and the proximity of the close to the 200 day EMA one would expect to see some buying support emerge, but in current market conditions that cannot be relied upon.