Trading AIG: Playing the Walking Zombies

If you’ve been watching the markets at all, you will undoubtedly have heard that AIG has had a massive run. It was not long ago that the stock was trading for a little more than a dollar. So the company engineered a 20-for-1 reverse stock split, meaning that if you at 20 shares valued at $1.00 each, you now had 1 share valued at $20.00.

On June 30^th, the company proceeded with the reverse stock split and the new shares started trading at $23.20 – the equivalent of $1.16 before the split. Within days, the stock plummeted and stockholders cried foul. By July 10, AIG had fallen to $11.74. The press had a field day, and the chorus of “who thought that one up?” was loud and persistent.

But then something curious happened. After drifting in the $11.00 -$13.00 range for almost a month, the stock took off, hitting $22.00 on August 5, 2009. No big deal, many said. After all, $22.00 was equal to $$1.10 on a split-adjusted basis. But the stock kept going up, hitting $28.70 within days. A few days later, it had drifted down to $23.42. And then, the stunner – the stock took off, hitting $50.23 today. Some are saying that AIG could hit $100 soon.

So before going on, let me state clearly why I’m even bothering to look at this. Let me say straight out, I’m not recommending this stock and if I were managing a client’s portfolio, I wouldn’t even mention it. But I think there’s a lot to be learned about the markets here, and I’m always interested in seeing what the logic might be behind the behavior. After all, someone, somewhere, is making these decisions. So mainly, it’s about seeing what we can learn. A secondary reason is that we will see similar situations come up again – Citi is looking at a reverse split, and that might be just around the corner.

Now a couple facts for context. There was a huge short interest in AIG. Even as of August 15, 24 million shares were sold short. As of today, the stock has a total market cap of $7.25 billion, even after the run to $50 a share. That’s far, far outweighed by the $180 billion of credit that the government has extended to the company. In late July, Catherine Siefert, an S&P equity analyst, estimated AIG’s common tangible common equity at negative $336.62. In Q2, reported early August, Siefert thought that tangible common equity had inched into the black, but that was due more to accounting than to any change in fundamental value. Still, the trading in AIG is rampant, and according to CNBC, it’s the retail investor at work: the average number of shares traded is 219.

So given all these negative facts, why the climb in AIG stock? Reasons are swirling, including talk of a debt-to-equity swap, a new CEO, promises by the new CEO to slow down asset sales. I find all these explanations unsatisfactory. What makes much more sense to me is that traders are taking advantage of short sellers squeezed into a corner.

Consider this. If you had a lot of money, you would buy shares of AIG and drive the price up. The short sellers would have to cover, driving the price up further. And you would buy the shares knowing that if the stock starts to move up quickly, other day-trading buyers would jump in, and the short sellers would have no choice in the matter. That would spark the move up. After that, the momentum guys would jump in. And more short sellers would cover. And more momentum guys would follow, too. And then, the retail guys would jump in. And then you would sell. If you had lots of money to play with, and were close enough to the markets to react quickly, this would be a pretty good formula for making some dough.

One precedent to support this theory: look at Citi before the conversion of government debt early this year. Everyone knew that Washington would convert their debt (actually, preferred shares) into common, flooding the market with shares and diluting existing shareholders. Short sellers piled in, so much so that it was pretty much impossible to find any more shares to short. The government’s conversion rate had been announced, and a little math would value Citi in the $2-3 range. Despite all the short interest, the stock climbed to the $4 range, squeezing the shorts. Months later, when the government converted its shares, Citi eventually drifted back to the $2-3 range in July. Somebody made a lot of money squeezing the shorts.

So does AIG go to $100? It’s within the realm of possibility. Keep in mind that $100 is only $5 pre-split. Still, it’s a risky game. AIG could go to $100, or it could go to $10. And at some point, the run has to end. Those that got in early will take profits, and that will put significant downward pressure on the stock. Also, many bought AIG when it was a $3-4 stock. So as AIG rises to the $60-80 range, a lot of those players will be looking to exit. I think AIG has some more to go, but somewhere in the $70 or greater range, it could swing the other way.

A lot of people wonder why you would buy a stock that is worth nothing when you do the math. Someday, the government will make a decision about what to do. But frankly, that day could be a long way off, and forcing a reconciliation of the books anytime in the near future would just put a huge loss on the government’s books. No one wants to do that.

So in the meantime, AIG is a big trading vehicle. And something else to notice: the move in AIG comes when other options have been exhausted. The good stocks have had their move and have stalled. Take Goldman Sachs, best in breed: it’s stalled in the $160-165 range for several weeks now. The market is not ready to take the “good” stocks such as Goldman any further, and so it’s picking through the trash.

If this interpretation of AIG is correct, then we should see similar action in Citi if it does a reverse stock split. We may also find similar action in other forsaken zombies, Fannie Mae and Freddie Mac. Perhaps the moral of the story is that even in trash, there’s some opportunity. Time will tell.

Ming is long Citi and Freddie Mac, and has no position in AIG or Fannie Mae.

August 26, 2009 - Caution Recommended

In the lazy days of August, it’s easy to not do much. The market, while still trending up, is fairly lethargic: volume is low, indices see little movement. People are on vacation, and it’s easy to let our attention drift.

Still, wisdom dictates that it’s the best time to look at the porfolio and plan for the coming year. The September to November period has historically been a tough time for the markets. I used to wonder why, but it makes sense: it’s only human nature to take this time and look at the prospects for the next year. Our New Year might be in January, but psychologically, we still carry the “school year” starting in September.

The markets have had an amazing run. So much so that the S&P is trading at a recent PE high of 19x (based on diluted earnings from continuing operations), according to research firm Bespoke Investments. To give you perspective, the S&P’s PE has been as low as the 10x range in the last year , and hasn’t been as high as 19x since the 2002-2004 period.

The recent run has also driven out the short sellers in the market. Bespoke also calculates that short interest as a percentage of float for stocks in the S&P is now at 6.9%. The last time short interest was this low was in February 2007, before the recent market turmoil. Back in early August 2008, short interest was nearly 12%.

In sum, the market hasn’t been this bullish in a long time, and that alone is enough to bring out the contrarians and the bears. Despite the year recent year highs of the indices and the failure of bears to drive the market down, calls of froth in the market abound. Many are saying that we are topping.

The bears may very well be right, but I prefer to look at things in several different ways and see if I can come up with the same answer. The one thing that favors the bear argument: the market needs good, hard economic news to drive it higher. In recent months, we’ve had a rally based on cost cutting, “less bad” news and money on the sidelines playing catch-up. All of these market drivers will eventually exhaust themselves, and we will need new catalysts to keep things moving upward.

And what would those catalysts be? Earnings and industrial production statistics in Q3 would have to be favorable. At this point, that would mean revenue increases, as opposed to cost cutting. That in turn means somebody has to be spending. And thus the problem – who would that be? I think the consumer will be in hibernation for years to come. For the consumer, it’s like gaining weight: very easy to put on several pounds quickly; it takes a long time to take the weight off (believe me, I know). Another way to think of it – consumers are headed to Target and Wal-mart before they go to Saks, Nordstrom’s or Bloomingdale’s.

And what about businesses? It’s not clear by any means that they’re spending. The decline in unemployment would say that businesses are cutting less aggressively, but the fact remains, unemployment is still high. Last quarter’s earnings reports still showed year-over-year revenue declines for companies selling to businesses, so there’s no clear catalyst there. The only thing we can be sure of at this point is that costs have been cut and inventories are being worked off.

And finally, what about emerging markets and the much talked about China? Here, I think the talk of China as an engine of growth is overblown. China remains export dependent, and despite its high rate of growth, is not yet a consumer economy on the scale of anything in the West. True, China has been buying commodities, but it hasn’t been just for production. China has been a trader and a speculator, buying and stockpiling commodities when prices are low. That means China will eventually stop, or at least slow down purchases, especially as prices rise. I think that relying on China for further growth would be too much.

In commodities, there is a dynamic that could eventually support prices, and that’s basically the depletion of inventories. As we work off supply, we will eventually have a situation where we will have demand but limited supply, and that would drive prices up. I don’t think that would happen immediately, but markets could react to the expectation of this kind of condition within the next 3-6 months.

So today, we have a situation with a big rally behind us and no clear catalyst for a continued rally ahead of us. In the short term, we also have no clear catalyst that would drive us down, and given the amount of buying in recent months, coupled with very low short interest, it would take significant bad news to bring us down as well, in my opinion. The bears haven’t had much success in recent weeks, and that situation could continue.

Still, with lots of space below, the situation calls for caution. That means placing stops under stocks, buying puts, and/or taking profits. For the moment, caution is highly recommended.