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Short Covering Can Feel Like an E-Ticket Attraction

August 5th, 2009


08.05.2009 original publish date
11.05.2010 repaired broken links
10.01.2012 update

Short Covering Can Feel Like an E-Ticket Attraction

Investor Education Series by Net Advisor

Today (08.05.2009), AIG soared 63%, CIT up as high as 55% and other weak stocks such as Fannie Mae (up 29.82%), Freddie Mac (up 31.15%), General Growth Properties, Inc. (up 22.28%), Ambac Financial Group, Inc.
(up 34.07%), PMI Group, Inc.,  and MGIC Investment Corporation each up over 19%.

WHY?

Two words: “Short covering.”

Many short sellers had been anticipating the net value of these companies to be zero. They may be right eventually; and technically they are correct. All of these companies have terrible balance sheets are laden with debt and some like AIG, Fannie Mae and Freddie Mac have huge government backing to prevent a collapse in other major financial companies.

AIG also moved today in anticipation of a new CEO – the 4th CEO in 14 months – and the hope that upcoming earnings may be better than expected; or at least not as bad as previously forecasted. The move sent short sellers rushing in to cover their positions by purchasing AIG stock.

Why 4 CEO’s at AIG in 14 months?

Maybe $1.00 a year salary just doesn’t cover the night mare the CEO’s have to go through to uncover, and figure out how to stabilize the company while dealing with heavy government influence over the company in its $182 Billion bailout (Source: MarketWatch – PDF).

Squeezed All Over
Whenever a stock has a outstanding short interest, at some point these positions need to be bought back (“covered”) in order to close a profit or stop a loss. When a massive number of short sellers all rush in to cover their short, the underline stock can often soar. Now hop on with the day traders, and momentum players, and that can further push the stock higher, forcing more shorts to cover their position. The result of all this is called a “short squeeze.”

Stocks that have large percentage up or down movements can also trigger a margin call, which a person is required to put up more money to maintain the position or be forced to liquidate some or all of the position.

However, keep in mind that because some of these low priced, high risk stock go up on a short squeeze, does not mean the bottom is in these stocks and its “safe” to go in and buy them again. When the buyers stop buying and the shorts have covered, these stocks will tend to fall again: Where is anyone’s guess.

Massive short covering happens repeatedly throughout market history, and even recently with most every bankrupted stock over the last year, such as GM, so this is nothing new.

CIT Group up on Short Covering
There was no major specific news reported today with CIT. There was several positive articles [1] [2] on commercial real estate, that suggested thing may be not so bad as foretasted. The result which sent the ETF, IYR up. General Growth Properties soared 22.28% in the rally today.

Is this a sign to jump in or could this be a near market top?
In the case of General Growth Properties they are still under a Chapter 11 bankruptcy.

“On April 16, 2009, General Growth Properties Inc along with its affiliates filed a voluntary petition for reorganization under Chapter 11 in the US Bankruptcy Court for the Southern District of New York.”

— Source: GGP, 04-16-2009

As for Fannie Mae and Freddie Mac, their stock equity is still technically worthless. But buying worthless equity did not stop people from rushing in to buy General Motors stock either.

Investors need to keep in mind that one day or a few days do not make a trend.

Traders might have a field day in these highly volatile stocks as long as they get in before or early in the move, and get out before every else does. Investors also need to keep in mind that these said stocks may not be the best investment out there; that they are very risky, speculative and contain much higher than normal risk.

Often highly volatile stocks may be seen as being in a Bearish period of uncertainty. Eventually the stocks will find their true value.

The overall market has priced in a huge bet on recovery with no errors expected since the March 2009 lows. Even with this latest rally, we really have just returned some of the losses to back to November 2008 levels.

Yesterday, NASDAQ broke above the 2000 level for the first time in two years, and there was much fanfare over this mile marker.

07-30-2009
Nasdaq Composite Index briefly topping 2,000 for the first time in almost two years

Doesn’t this NASDAQ story sound familiar?

12-30-2003
NASDAQ broke above the 2000 level for the first time in two years

Keep in mind that NASDAQ is still trading down 3,000 points (about 60%) lower than its March 10, 2000 high. So it will take many years, decades likely for this index to recover, and may not happen in our lifetime. NASDAQ is still in a technical Bear Market, but that does not mean one can’t make money.

There are plenty of stocks that have performed quite well this year including but not limited to tech stocks such as RIMM, GOOG, AAPL, MSFT and IBM.

Oftentimes near market tops or short term market tops, smaller priced stocks and more risky stocks tend to make big moves. This happened during the .com top in late 1999-2000. So investors be careful of the short term stock movements and understand WHY these movements are happening. It is not always a buy signal; it could be some other event such as short covering that is moving the stock higher near term. Again, this is not a fundamental value play as it is a panic play.

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