08.10.2009
Junk Stock Rally: Ka-Ching or Ka-Boom?
original article written by Net Advisor™
I have actually been amazed at how few questions people have asked me with regard to the recent surge in low priced “junk stocks.”
I define junk stocks as companies that have several of the following:
(1) Massive debt.
(2) Generally also have negative equity.
(3) Negative earnings.
(4) Is owned or mostly controlled by the US Gov.
(5) Is still trading under $5.00 even if you back out any reverse splits.
(6) Is bankrupt or technically insolvent.
(7) Is trading on the pink sheets (OTC BB).
(8) Had previously been “left for dead” as a stock (see 3, 4, 5, 6 and sometimes 7). This has happen before with the telecom stocks – the ones that did not go BK.
So who are some of these junk stocks?
We’ll some of these stocks are ones I have been writing about for the last 2+ years (example 1, example 2, example 3, example 4, example 5, etc). See post history for more (“add me as contact” to view post history).
Examples of so called “junk stocks”
AIG, CIT, CROX, MBI, ABK, PMI, MTG, FRE, FNM, C, DRL, RAS, MTLQQ.
Please don’t confuse these (mostly listed) “junk stocks” with often technically worthless penny stocks that are traded on the pink sheets or OTC Bulletin Board (OTC BB).
These stocks (see example above) have experienced 30 to 100%+ moves recently, many have had these moves in a single day.
So what is happening?
I covered this before and I am saying it again. Many of these stocks have been previously and heavy shorted. As the market moved higher, these stocks lagged behind the rally.
The market is technically in overbought territory, so now small caps, and “junk stocks” tend to move that did not move before.
A year ago the term “junk stocks” was not common. Recently we now have a new common frame of reference for junk stocks.
As of today, Yahoo Finance was showing that AIG is losing $726.00 a share. Based on today’s close of $28.70, that would still result in negative equity (+28.70 – $726.00 = -$697.30).
Fuzzy Math?
Today (08-10-2009), Freddie Mac (FRE) traded over 387 million shares. The three month average daily trading volume was about 8.9 million. The stock surged 128% after (allegedly) reporting a profit and successfully selling $4.5 billion of 3 year notes.
Why is some of this fuzzy math?
Freddie Mac attributed much of the profit to “one-time accounting adjustments.” This means they were able to make things look better than they really are. This is really an accounting trick, but apparently it is acceptable under GAAP. (accounting adjustment example). Earlier this year, the US government allowed corporations under the Financial Accounting Standards Board to change how assets are valued.
Conveniently, this accounting rule change came PRIOR to the so called “bank stress test.” The result of the accounting rules change helped banks have better earnings, thus pushed banks stocks higher.
Previous articles on the 2009 bank stress test:
“Will banks Q1 results be positive or negative?”
“What are the 19 banks that have taken the stress test?”
So why are “Junk Stocks” still moving higher?
(1) Speculative buying + short covering + margin calls = increased stock price.
So should I jump on the “Junk Stock” bandwagon or run for cover?
Investors should probably avoid this kind of speculation. This kind of risk is for those who: (a) can afford to absorb losses; (b) are emotionally equip to deal with high beta (volatility); (c) have sufficient experience in trading, especially in high beta stocks.
I watched people today buy as little as $20 worth of FNM September $1.00 call options. I got a bit nervous. You’ve got to be kidding me? Spending $20 bucks on an option? The commission at a discount broker probably ran at least $15.00. Then it will be another what $15.00 to get out of the option. Thus the option will have to more than double in order to get close to breaking even. This does not make good investment sense.
Example:
Note: 1 stock option contract = 100 shares of stock
Thus Investment: 1 (one) option contract @ 20 cents = 100x .20 cents = $20.00
This may suggest too many small investors with little to no money are gambling in stocks they really have no business being in; and they are looking for a winning lotto ticket. Now, that $20.00 investment, make that $35.00 (with a $15.00 commission) may not be a big risk, but professional traders and institutions do watch trading volume and order size. If there are too many tiny trades (odd lot trades – less than 100 shares), they get nervous and should be thinking there could be a top in the stock anytime.
But with several stocks such as Citigroup, Fannie Mae and Freddie Mac for example, trading volume has surged. Generally speaking, high trading volume is considered bullish for a stock.
Trading Tip:
High trading volume on the upside = Buying interest in stock.
High trading volume on the downside = Possible capitulation (bottom) in the stock.
Clearly the buying interest has surged, but again, keep in mind there is combined short covering and heavy speculation driving these stocks. Needless to say, there seems to be momentum in some of these junk stocks.
Quick Junk Stock Note:
Hope and pray all one wants, but old GM stock officially and legally now called “Motors Liquidation Company” (MTLQQ) is going to be history like the dinosaurs. I have been Bearish on GM for over a year. Trade it if you want (I would not) with 100% risk capital, but a lot of people will one day have no chair to sit on when the music stops.
The question everyone wants to know is, “When will this gravy-train (junk stock rally) end?” Good question. Answer. I don’t know.
What to look for – Sign for Junk Stock Top:
If trading volume slows, this is a sign that the buyers are already in the stock and the short sellers may have already covered. Consider just one 25-30% up move probably triggered some margin calls on a host of short sellers. This is where short sellers must put up more money or marginable stock to keep the existing short position open, or they will be forced (by their broker) to buy back the short via a margin call, pushing the stock price higher. The result of all this produce a short squeeze.
So can I make money on junk stocks or what?
Traders with risk capital have at it. Sure you can make money in these junk stocks if you catch them correctly. Just keep in mind that you can also lose money just as quickly, even lose money overnight when the market is closed. The market can open next day with either a high or low bid, and there is nothing one can do about this unless they hedged the prior trading day.
One should assume to expect a total loss on these high risk trades. So if you are ok with that worst case scenario, and you can afford to absorb a total loss, then you go into the position knowing that.
If one goes into a trade “hoping,” that it will go higher and they can make some “quick money,” yet they cannot really afford to lose much or any money, then that person should steer clear from this kind of speculative trading.
For the “long term investor” in speculative stocks: Sure, maybe, maybe, maybe, one or more of these stocks actually turn around, but MTLQQ is not one of them. Keep in mind that these “junk stocks” are not the same company as they were 2 years ago. Many troubled (financial) companies have been shedding assets, selling more stock to raise capital and some under government control or influence or both (partial list).
08.11.2009 update:
Disclosure Note: Exited FNM long call option trades today; then entered back in it again; then exited shortly after. Yes, all the FNM trades were gains too. The only loser discussed in this article is AIG. Still got another week for AIG to plunge before the Aug 21st options expiration. Again, as a matter of course, don’t have time to update all the trades. Good Luck!
08.21.2009 update:
The AIG put was a small loss. Aug put option expired.
Risk Disclosure:
Additional information regarding options investing. A required read before investing in options:
Characteristics and Risks of Standardized Options
Financial Disclosure:
At time of post, author and or author’s client(s) previously held, is currently holding, or trading positions in C (long stock + long calls – exited), AIG (long put – holding), FNM (long calls – holding), CROX (long calls – exited). Please note, author does not have time to update every trade or change in position(s). Author could be back in the same securities or in other securities without notice. Author of this article has over 20 years market and professional trading experience in especially equities and options.
General Disclaimer:
This is not a recommendation to buy or sell any of the securities mentioned. Trading/ investing in especially speculative stocks and or options are risky. There is a higher chance of loss in speculative trades. That higher risk is a trade off for potentially a higher gain. There can be NO assurances that any of the trades will be successful.
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