Why Do Stocks Often Pop After a Spectacular Crash?

by Jeff Reeves | April 9, 2012 1:00 am

Why Do Stocks Often Pop After a Spectacular Crash?

AskTheEditor logo2 300x200 Why Do Stocks Often Pop After a Spectacular Crash?[1]“Why do horrible investments always seem to bounce in the days after a big rout. Take Sears (NASDAQ:SHLD[2]) recently. Do gullible investors really think they were buying a bargain and the gains will last?”

Great question – and great example with Sears. The short answer is that some investors may be bargain hunting, but the “short squeeze” is really to blame in the case of Sears.

While I’m sure there are investors out there who were bottom-fishing SHLD (and enjoyed a nice 95% run year-to-date I might add), it’s important to acknowledge that the uptick in shares has a lot to do with short-covering — not volume from conventional buyers alone.

Hopefully you know all about the practice of short selling[3], or profiting as a stock falls by selling the company first and then buying at back at a lower price. The simple reality of this trade though is that everyone who sells a stock short eventually has to buy it back eventually – “covering” the other side of their trade. If you sell first at $5 and watch the stock drops to $4 , you make a buck per share on the trade. But if you sell first and the stock rises to $6 or $7? You lose. Simple as that.

I recently wrote a column about the short interest in Sears[4] being over 40%, and how many traders made money off the retailer’s meltdown. Shares went from $78 around Halloween to about $30 around New Year’s — a profitable trade for anyone betting on the downside.

But those who bet the slump would continue from $30 down to $15? Well, that wasn’t very smart.

You see about 10 million shares of Sears were held short early this year. Those folks had to buy back eventually, even if the price rose above what they already locked in as a sell price. So as sears moved from $30 to $40 they panicked, hurried up and tried to “cover” the trade before they lose even more money. That resulted in the stock price moving higher as they bought shares back, since buying pressure ultimately moves equities higher. That drove out more short-sellers … and the cycle continued all the way up to $60 or so.

Welcome to what is called the “short squeeze.”

Consider that while the average daily volume for Sears was just about 1 million shares in December, there were 10 million shares held short. That means if EVERY trade was a short-seller buying to cover his trade, it would take 10 days to process them all! You don’t want to be the last one to the exit in a scenario like that.

Clearly when there is such a huge amount of short interest, there will be days when the “buyers” overwhelmed the sellers and result in significant  share price appreciation. That’s what happened to Sears in the last few months.

But don’t be fooled. It is not a sign that Wall Street is taking heart and getting back into a given stock. Oftentimes, it is really just traders covering their shorts. I remain convinced that Sears is in trouble, and could very well see a slump from here.

InvestorPlace contributor Beth Moon wrote a great analysis of Sears recently[5] that lays out the reason for the run and the risks to holding this stock any longer.

But broadly speaking, always be aware that short-selling can fuel a big bounce in much-maligned stocks. Just because a stock surges 50% or more in short order isn’t always a sign that Wall Street is optimistic… it could just be a sign that the dyed-in-the-wool pessimists are no longer as bearish as they once were.

Or put another way, the stock may be “less bad” than some had thought but that doesn’t make it a good buy.

Jeff Reeves is the editor of InvestorPlace.com, and the author of “The Frugal Investor’s Guide to Finding Great Stocks.”[6] Write him at editor@investorplace?.com or follow him on Twitter via @JeffReevesIP. As of this writing, Jeff did not hold a position in any of the aforementioned securities.

Endnotes:
  1. [Image]: mailto:editor@investorplace.com
  2. SHLD: http://studio-5.financialcontent.com/investplace/quote?Symbol=SHLD
  3. the practice of short selling: http://investorplace.com/2010/07/short-selling-stocks-shorting-options-trading-investing-strategy/
  4. short interest in Sears: http://investorplace.com/2011/12/3-surefire-stocks-to-short-soda-bks-zagg-shld/
  5. wrote a great analysis of Sears recently: http://investorplace.com/2012/03/is-it-finally-time-to-sell-sears-holdings-shld/
  6. “The Frugal Investor’s Guide to Finding Great Stocks.”: http://www.amazon.com/Frugal-Investors-Finding-Stocks-ebook/dp/B007KB9CSI/ref=ntt_at_ep_dpt_2#reader_B007KB9CSI

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