Frothy trading in bankrupt companies, penny stocks sent red flags that a pullback was due

Bubbly price moves in the stocks of bankrupt companies, a jump in the number of bullish investors and surging activity by small investors in stock options are all signs that the stock market may have run too far, too quickly.

There’s even been a big rally in stocks trading under $1 per share,  which racked up an average gain of nearly 80% in the past week. 

With the S&P 500 more than 45% off its low, analysts have been seeing signs the market is overbought and could be ready for a rest. But the market’s strong gains are also a magnetic lure for some retail investors, who feel like they haven’t been invested enough, and for others who are finally beginning to trust the market’s comeback.

“Now you have frothy retail behavior on top of stretched sentiment on the part of professional investors, and it’s definitely a warning sign,” said Peter Boockvar, chief investment strategist at Bleakley Advisory Group. “Does it really matter today, or does it matter two weeks from now? But from strictly a contrarian standpoint, it’s got to be a red flag. It’s not making a long-term statement. It’s not telling you it’s the end of the bull market. It just tells you right now, at this moment in time, there’s a lot of speculative behavior that should be heeded in the short term.”

Stocks skidded sharply in early trading Thursday as some of that froth began to unwind. Hertz was down 13% on Thursday morning following a 39% drop on Wednesday.

Boockvar said Investor’s Intelligence data now shows a reading for bulls at 56.9%, from 53.5% last week, the highest since January and even more than the 54.7% when the S&P hit its all-time high in February. Bears have fallen to 22.5% from 22.8% last week, and 41.7% in March. The spread between bulls and bears at 36.3 is now the widest since mid January. 

According to Sentiment Trader, small-lot options traders are in a “frenzy,” and their activity also dwarfs the amount of trading at the market highs in February. Sentiment Trader points out that the smallest traders, with volume of 10 contracts or less, bought to open 7.5 million call options on stocks at the market peak in February. This week, they bought 12.1 million of similar contracts.

Add to that some pretty wild trading in the stocks of bankrupt companies like Hertz and Whiting Petroleum. Hertz stock hit a bottom of 40 cents on May 26,  four days after its bankruptcy filing, but its stock hit a high of $6.25 since then. On Wednesday, it fell sharply to $2.52 per share, a decline of 40%. Whiting was also hit hard Wednesday, along with bankrupt retailer, J.C. Penney.

“There’s always speculation, the hot sectors, the hot areas of the market,” said Jeff Rubin, head of research at Birinyi Associates. “In every bull market, there have been periods of speculation that in hindsight look foolish.” But Rubin said the frothy action does not necessarily carry a warning.

“Two years ago, anything related to cryptocurrencies were super hot, and after that it was anything related to the pot stocks that were super hot,” said Rubin. He also mentioned Pets.com, the poster child for bubbly internet stocks in the late 1990s that no longer exists.

Citadel Securities Institutional Equity Derivatives team, in a note obtained by CNBC, studied the 29 stocks in the small-cap benchmark Russell 2000 with a share price less than $1. In five trading days through Monday, the group was up an average of 79%. Denbury Resources, Noble Corp., and Palatin Technologies are some of the stocks that were trading below $1 per share in the Russell 2000.

“This all amounts to what seems like a retail short-squeeze feeding frenzy that has reached blow-off top proportions,” the Citadel Securities Institutional Equity Derivatives team said in the note. 

Retail investors would have found some cheap prices amid the rubble of the March sell-off. The airline sector, up 45% in the past month, had been depressed with American Airlines and others trading in the single digits. Those investors would have seen their money more than double.

Some strategists said it appears individual investors are getting sucked into the “bankruptcy trade.” Others said that high-frequency traders, combing the market for opportunities, may also have set their sights on those stocks to capture their dramatic moves on a percentage basis. Stocks in bankruptcies can end up worthless.

“There’s really two types of people who invest in those sorts of things. People who are outright speculative, and those who are specialists who have done the math and understand the risk for the stocks and bonds,” said Ed Keon, chief investment strategist at QMA. “You also mostly see those type of investors on the bond side of things, rather than the stock side. There are those that do it properly. It’s a specialist game and it’s not easy to play.” 

Keon said the fact that more people are at home due to coronavirus shutdowns may mean they have time to look around at the market, more than they normally would have at the office. “They may have a bit more time on their hands to look at their portfolio. Some people may be speculating in different corners of the market. That’s usually not a good sign,” he said.

“Remember back in the day in 1999, you go to a cocktail party, and it seemed like everyone was buying tech stocks on margin, which was fantastic for awhile,” said Keon. “There are always some fools taking a flier on a risky investment but it seems to be more intense if you have the market move up.”

Keon has become more cautious on the market, which he sees overvalued by some metrics. Investors venturing into the riskier areas may have made some good returns on the rebound in airlines and other reopening plays. “They made some money and that encouraged people to do it. It’s a good idea until it isn’t,” Keon said.

One measure of value, the S&P 500 price-to-earnings ratio on forward earnings is above 22 times. The long-term average is below 20.

“We’re not super bearish. There’s a lot of momentum. We’re making progress on the disease. We’re making progress on the economy,” Keon said. “We look at different measures of valuation.”

Katie Stockton, founder and managing partner at Fairlead Strategies, said for the investors who are playing bankruptcy stocks, neither Hertz nor Whiting Petroleum are showing any evidence of being able to sustain their gains. Stockton, a technical analyst, said she does not see a confirmation in the charts.

“For me breakouts always need to be confirmed, not just in price but in time,”  she said. “What we’ve seen is these very quick snap-back rallies for these bankruptcy companies. There’s not enough to suggest they’re lasting.”

She said Hertz did move above its 50-day moving average but did not hold it. “It doesn’t confirm a market breakout or medium-term momentum.”