If you trade stocks, I’ve got some bad news for you. You might be thinking that stocks go up in price because of whatever is going on with the company. You might be thinking that a value of a company’s stock is directly a reflection of the strategic choices, industry developments and management decisions involved in the company. I really can’t fault you for thinking this way because this is how most intelligent people would be expected to think when it comes to these business organizations. This is a very reasonable and logical way of getting at the value of a company.
Unfortunately, it’s also inaccurate. In fact, it has no bearing on reality. What if I told you that there are lots of well run companies with a tremendous amount of potential and which are tried and proven, yet the stock market considers them dolts? I’m not saying that they’re worth nothing, but their stocks are not appreciating at a healthy enough clip compared to how the rest of the market is performing. They definitely can’t hold a candle to the current darlings of the stock market.
What if I told you there are companies that have a lot of debt, have structural problems, don’t have that many products in the pipeline, are relatively new, or flat out clocking loss after loss quarter after quarter, yet they’re worth a lot of money? In fact, in some cases, the stock market seems to have fallen in love with them.
How do you make sense of these two scenarios? These are both rooted in reality and both of these situations are always in effect. Well, let me tell you, I raise these two seemingly contradictory stock market realities because I want to call out the fact that the stock market values a company’s stock not primarily because of some sort of intrinsic value. Instead, it values the stock based on popularity.
It really is a popularity contest. Don’t be surprised when a stock that really should be in the basement is soaring high because a lot institutional investors are giddily trading this stock backwards and forwards among themselves. They think that the stock has so much going for them. It is not rooted in reality, it is not realistic by any stretch of the imagination, but here we are. The stock’s heading straight into the stratosphere.
As alarming as this reality may seem to you, this is actually a tremendous opportunity. As you already know, there are two major ways to make money off the stock market. First, you can buy long. You can buy a stock at a low price, wait, and then unload the stock once it has reached a much higher price. The difference, of course, is your profit.
You can also do things the other way around. You can sell a stock while it is priced very high, and once it drops like a rock and hits bottom, you buy it back. What you’re really doing is when you sold it, you borrowed the stock from a market maker like a brokerage and you sell the stock. You dump it. And then once it hits a low enough price, you buy it back. The difference, again, of course, is your profit. In this context of short selling, over-hyped stocks make a lot of sense.
So how do you find stocks you can dump in short sales? Here are 5 signs.
Sign #1: Significant price hikes without matching surge in volume
If you notice that a stock is spiking up in price, but the volume doesn’t seem to change, it would seem that a lot of the upward momentum is made up by the relatively small volume of being bought and sold that pushes the price up. In other words, the upward momentum is really based on a relatively small portion of the total stock available.
This represents a major imbalance in the attitudes of the people actually holding stock. In other words, the really bullish people, these are the ones that are pushing the stock up are actually quite small and they don’t really own that much of the company. When reality catches up to the company, you can bet that those people will be outnumbered. And this can lead to a massive erosion in the value of the stock.
Sign #2: Significant price rise at low volumes for high individual investor stock
If you notice that most of the owners of a stock are not institutions and the price increases at low volume trading, be on the lookout. Seriously. Start looking for signs that individual investors might turn on the stock.
Again, the same dynamics play out as the situation I described above. The big difference here is that there might be a stampede effect because we’re talking about a high individual investor ownership proportion. They can be more skittish or driven by a market herd mentality than investors buying in massive blocks.
Sign #3: PR driven news with little relevance to earnings
If you notice that a lot of price movement of a particular company is driven by press releases or news about the company that have nothing to do with earnings, you might want to pay close attention to the company. I’m not saying that you should jump in and sell immediately. Instead, pay attention to the actual rise of the price and how much hype circulates about the company over the short term.
Usually, hype to certain companies acts like a fuel. If not enough hype or positive news is forthcoming, the stock price rocket runs out of fuel. You know what happens next. That’s right, it starts coming down to earth.
Now, the rule of thumb here is that as long as this news hype has nothing to do with immediate earnings or even mid-range or long-term earnings, the more you should pay close attention. There might be something going there and it might present a nice short sale opportunity.
Sign #4: Significant price hikes with no matching increase in cash flow
If you notice that the company’s stock is just going through the roof, but when you look at its quarterly filings, its cash flow either remains stagnant or actually starts to sink, you might have an over hyped stock on your hands.
Now, keep in mind that there are the factors to this. Maybe the company is in the talks to get into a major distribution deal or maybe it’s in the process of being bought out by another company. There are other reasons why the price is going crazy but when you take a look at cash flow, this is like taking the pulse of a patient. This says a lot about the overall health of the company.
So be very suspicious and be open to potential short sale opportunity, but understand that this factor, in and of itself, is not dispositve. Don’t jump in immediately if you see this. Look at other signs of an overheated stock or a stock that’s basically being positioned to bursting sooner rather than later.
Sign #5: Huge price pops with flat earnings per share
If you look at the earnings per share performance of the stock and you don’t really see a change in the company except for its psychotic stock price movements, you might want to start digging deeper. Again, just like with cash flow analysis, this, in and of itself, should not push you to get off the fence and starts shorting the stock. You have to look at other signals. You have to look at what else is going on. But this is definitely a red flag.
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