A Speculative Fervor in Penny Stocks

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April 20, 2006

7:30 PM EST

There is a Speculative Fervor in Penny Stocks,

With Trading Approaching Bubble Status

When we talk about and measure "dumb money", what we're really looking for are those traders who tend to get bitten by the speculative bug at precisely the wrong time.

I don't mean anything disparaging by the term "dumb", as most are likely intelligent folks who just tend to jump on trends at inopportune moments. It's sometimes difficult to isolate these traders for sure - often we have to guess that the ones we're measuring are the ones we intend.

There are some indicators which allow us to specifically measure specific types of traders. The ROBO put/call ratio is one, and the AAII sentiment survey and odd lot short sales are a couple more.

Another measure that I've written about previously that also allows us to isolate these traders is the trading pattern in penny stocks. While we don't know for sure who's trading these stocks, it's a pretty good bet that Goldman Sachs isn't wading into the pink sheets.

Penny stocks go by several different names, such as Micro Caps, Bulletin Boards, OTCs or Pink Sheets, depending on who you're talking to. They are stocks that have publicly available shares but the companies do not meet the listing requirements of major exchanges like the New York Stock Exchange or Nasdaq National Market.

These shares are often very low-priced, usually under $1 (thus the term “penny stock”) but not necessarily so – some trade at prices as high as $10. Most brokers allow you to trade the shares with no special suitability hurdle, though some do require such a thing. The stocks tend to be extremely illiquid and are a hotbed of stock manipulation schemes. It is an area best avoided by nearly everyone, which is why it is interesting when they're not being avoided.

When we see investors concentrate on stocks that are not subject to strict regulatory oversight, and instead have a high degree of risk on several different levels, we can conclude that there is a desire for speculation. Excessive desire to trade these lottery tickets should be a sign that things have gotten too far out of hand, and for the most part that tends to be the case – near market highs, we see extremely heavy penny stock volume, and near market lows that volume usually dries up.

In February, share volume in stocks traded off the major exchanges had mushroomed, nearly doubling the previous record that was set in January 2004. The latest figures that cover trading through March show yet another new record - this time more than 30% above February's record.

Traders in these stocks turned over an astounding 143,643,077,296 shares last month. That's alotta digits.

To put that into perspective, penny stock volume was 40% higher than NYSE and Nasdaq volume combined, which is saying something since there are about an equal number of stocks traded on each market.

The average stock on the NYSE trades for around $38 per share, while the average OTC stock trades well under $1 per share, so obviously the dollar value of the shares traded is vastly different.

Let's take a look at the dollar volume in the OTC market:

There was a 40% jump in dollar volume last month compared to the previous month, and it's up 140% since December. Other than the bubble months in 2000, last month's dollar volume was one of the highest in history, though it was well below those year 2000 highs.

Let's take a look at one more chart which will help us flesh out what these traders were up to. The chart below shows the total number of transactions done over-the-counter.

March's transaction volume was the highest in history other than December 1999 - April 2000.

So when we put this all together, what we see is this...at the top of the bubble in 2000, these guys were averaging 5,000 shares per trade at an average price of around $1. Last month, they averaged 82,500 shares per trade at an average price of $0.05. So they were committing about the same dollar amount per trade, but they were betting like mad with stocks that had the lowest average price per share in over a decade.

This was not due to just a few select stocks. The top 10 volume leaders listed in the pink sheets accounted for only 3% of the share volume and 0.2% of the dollar volume. The speculation was not concentrated on a couple pump-and-dump garbage stocks, it was filtered across a wide range of garbage stocks.

On a side note, the OTC volume indicators have now been added to the stable of regularly updated indicators, and you can see them at any time in the Cash section.

Conclusion: Push to New Highs Should Lead to

a Failure Into the Summer

Expiration Fridays tend to see high-volume, muted trading - only six times out of the past three years' worth of monthly expirations have we seen the S&P close more than 1% away from where it closed on Thursday. There has not been much of a bullish or bearish directional tint to these days.

The day after expiration, as I mention nearly every month, has had a decidedly bearish bias, with April showing no particular deviation from that pattern.

In the intraday notes, I'd been suggesting that the first attempt at new highs among the indexes should be met with a wave of selling pressure, which is what we saw today, but after that a (short-term) sustained move above those highs should be easier.

With the consistent weakness we typically see immediately after expiration, I don't know how likely it is that we see that move higher just yet, but it seems increasingly likely that we will get a run-up. I continue to feel, however, that such a rally attempt should be short-term in nature and would be a good time to significantly pare long exposure and initiate short sales. We should see this breakout fail as well, with lower prices going into the summer months. If it lasts much more than a week, or travels more than 3%, I'm likely wrong.

All the best,

Jason Goepfert

President and CEO

Sundial Capital Research, Inc.

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