Speculative Trading Lends Credence To “Rally Losing Steam” Thesis

A disturbing recent trend has emerged in the U.S. equity market and many are pointing to it as a potential reason to worry that the massive market rally over the last six months may be running out of steam. Investment strategists are concerned that a recent rise in speculative trading activity is signaling that the market’s dramatic ascent is getting a bit frothy.

This kind of trading is typically characterized by lots of smaller capitalization stocks seeing massive increases in trading volumes and dramatic price swings, often on little or no headlines warranting such trading activity. Indeed, in recent weeks we have seen a lot of wild swings in small cap biotechnology stocks as well as some financial services stocks that were previously left for dead.

For instance, shares of beleaguered insurance giant AIG (AIG) soared 27% on Thursday on six times normal volume. Rumors on internet message boards (not exactly a solid fundamental reason for a rally) which proved to be false were one of the catalysts for the dramatic move higher, which looked like a huge short squeeze.

Consider an interesting statistic cited by CNBC’s Bob Pisani on the air yesterday. Trading volume on the New York Stock Exchange (NYSE) registered 6.55 billion shares on Thursday. Of that a whopping 29% (1.9 billion shares) came from just four stocks; AIG, Freddie Mac (FRE), Fannie Mae (FNM), and Citigroup (C). Overall trading volumes this summer have been fairly light anyway and the fact that such a huge percentage of the volume has been in these severely beaten down, very troubled companies should give us pause for concern.

While not nearly as exaggerated, speculative trading like this is very reminiscent of the dot com bubble in late 1999 when tiny companies would see huge volume and price spikes simply by issuing press releases announcing the launch of a web site showcasing their products.

I am not suggesting the market is in bubble territory here, even after a more than 50% rise in six months, but this kind of market action warrants a cautious stance. Irrational market action is not a healthy way for the equity market to create wealth.

Fundamental valuation analysis remains paramount for equity investors, so be sure not get sucked into highly speculative trading unless there is a strong, rational basis for such investments. Companies like AIG, Fannie, and Freddie remain severely impaired operationally and laden with debt.

As a result, potential buyers into rallies should tread carefully and be sure to do their homework.

Full Disclosure: No position in any of the companies mentioned at the time of writing, but positions may change at any time

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3 Thoughts on “Speculative Trading Lends Credence To “Rally Losing Steam” Thesis

  1. I think the volume leaders are a good indicator of where the market is going. Ironically, much like real bulls, the herd follows the leader. If Fannie, Freddie, Citi and AIG are all overpriced, then the whole market will follow them off the cliff when they correct. Simply because they were leading the rally, even though many of the other stocks are still good buys. According to this method of prediction, tomorrow should also be a correction day 9/01/09. I had a feeling this would happen, but you called it on the record. Very nice. I have a growing confidence in your positions. :)

  2. Well, this post is about a month old and it looks like the ‘speculation’ has continued. There’s the odd blip but market keep going higher, particularly on weak dollar. Where does it end. I’m certainly sitting on the sidelines for now for fear of getting trapped.

  3. I tend toward utilizing robotic systems myself, but I can definitely accept the points you’re putting out in this post. You have more background and better viewpoints than many of the self-appointed gurus who are lecturing about trading on the internet. Thank you for the helpful article.

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