Four Rules That Will Protect Your Wealth and Boost Your Profits Even if We're Battling the British Contagion

By Keith Fitz-Gerald
Investment Director
Money Morning/The Money Map Report

With the recent market collapse, the subsequent U.S. Federal Reserve-negotiated sale of The Bear Stearns Cos. Inc. (BSC), and a central bank that's socializing trillions of dollars in debt in a misguided attempt to "fix" the credit crisis, many investors are very astutely asking: How much worse could this get?

My answer: A lot.

Right now the big concern is whether a potential new financial crisis in Great Britain - spawned by the "St. Patrick's Day Massacre" - will make the jump across the ocean and infect the U.S. financial markets. Fortunately for us, there are steps investors can take right now to position themselves for profit - and protect themselves from infection should this U.K.-generated contagion reach our shores.

But you have to know where to look and what to buy. And you also have to understand just what's happening right now. So let me take a moment to tell you just what's happening.

The "St. Patty's Day Massacre"

Late Wednesday night, my good friend Jon Markman, a noted financial writer and commentator, pointed out a breaking news story out of London that has yet to really hit on this side of "the pond."

According to a story that appeared overnight in London's Daily Telegraph, leading broker MF Global Ltd. (MF) informed clients that they'll need to put up "significantly" more cash to cover derivative positions.

How much more?

Try 260%.

MF Global has had a rough week already, Futures & Options Week reported. It started with the so-called "St. Patrick's Day Massacre" on Monday, when MF Global shares lost 65% of their value because of "a storm of negative news and inaccurate rumors about credit lines and investors," the F&O financial news service reported.

After starting the week at $16.11, MF Global shares traded as low as $3.64. They've subsequently rebounded a bit to close at $9.25, although they're still well off their 12-month high of $32.20.

Now here's the rest of the story. MF Global unilaterally increased margins on certain stocks [British small cap and U.S. shares] from 25% to 90% and clients were given until yesterday (Thursday) to either put up the cash or close out their positions.

Here's why this matters.

Many of the stocks at the top of the list are those preferred by smaller investors. If the institutions and individuals that trade them cannot meet the margin calls, we could see another round of "forced liquidations." In a market environment where the U.S. indices alone are up 400 points one day and down 300 the next, this added downward pressure can't be good.

If this happens, investors will rush to meet margin calls, and millions of shares could be "dumped" in any way possible. Add that into the ongoing market decline and you'll understand it if traders are feeling a bit like long-tailed cats in a room full of actively used rocking chairs.

Against such a backdrop, the potential buyers simply turn their heads and the "bid walks away" which is an expression meaning that buyers simply don't bid. Why should they? They know that they'll get a better - even lower - price in the future.

So traders have to settle for less.

A lot less.

Unfortunately, this only steepens and accelerates the stock market's already-existing downward spiral. Once that happens, all bets are off.

Now, bear in mind that what I am describing is the worst of all possible scenarios... a market with millions of shares for sale at a time when there is no liquidity to buy, meaning there are no buyers.

There are no guarantees that this will happen and I, for one, sure as heck hope it doesn't.

We've already seen our fair share of forced liquidations as hedge funds have unloaded for similar reasons here in the United States. But we've at least got to consider the possibility in light of what MF Global has told its clients.

All three of Europe's key indices - the London FTSE 100, Germany's DAX and France's CAC 40 - posted only moderate declines yesterday. So it appears that European investors have for now escaped the worst of what I've described. Indeed, it's possible that some of the dumping has probably already taken place. And many European markets are closed tomorrow (Friday) and Monday for a national holiday.

But New York is "taking the book" now and, after the Easter weekend, anything could happen. But there are two key things U.S. investors should keep in mind and watch for:

  • First, it remains unclear just how many U.S. stocks MF Global's clients still hold, or if there still could end up being a spillover into the U.S. markets.
  • And second, and perhaps the real question here: Given the fragile state of the U.S. financial markets, as well as many of the U.S. financial firms, how many U.S. firms - if any - will take similar steps with their clients in the coming weeks, drastically shifting margin requirements, forcing stateside investors to pony up big blocks of cash? If that happens, the impact could be quite remarkable, though not fun to watch.

So now the question is this: What's a U.S. investor to do?

I've got a four-point strategy that will keep you out of trouble should either, or both, of these scenarios become reality.

And here's the bonus: Even if they don't happen, these strategies are highly effective strategies in the kind of "whipsaw" markets that we've been facing of late.

There's No Such Thing as "Too Careful"

Rule #1: Your Best Offense is a Good Defense: This is the most important rule of all and can prevent a ton of trouble when it comes to growing your assets. After all, if you can't keep it now, you can't grow it later. Part of your defensive alignment includes the use of trailing stops. Even though you are convinced that your favorite stocks are the ones that will survive a downturn, there are no guarantees.

Rule #2: Stay "Balanced:" Globally diversified stocks and balanced funds may get hit if the selling starts in earnest, but history has shown that they're far more stable than those limited to any single market - which is why we've been telling readers since last fall to park the bulk of their money in funds of this type.

Rule #3: Seek Help From Hedges: Protect yourself with such investment choices as the Rydex "URSA" [Latin for "bear," as in "bear market"] Inverse S&P 500 Strategy Investment Fund (RYURX), which grows as the Standard & Poor's 500 Index falls. If you're more aggressive, there are also some of the so-called "2x" funds, which do the same thing but at twice the rate (and volatility). One example is the ProShares UltraShort Financials (SKF). Funds like this have done well as the financial sector has cratered in recent months.

One caveat: Inverse funds are specialized choices, and while the potential for upside in a down market is tempting, nothing is for certain right now.

And that brings us to the final rule.

Rule #4: Don't Try to Time the Markets: Especially now. Instead, think "safety and balance" and limit your positions - including the inverse funds - accordingly.

If you follow these rules, you'll be poised to profit in the long run. And in the short run, no single mistake will wipe you out - even if the lousy markets get the best of those around you.

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