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Another Wind for Stocks' Bull Market?

As Internet Mania Spreads, Someone's Going to Get Singed

April 22, 1998|WALTER HAMILTON

Just when you thought the Internet stock craze couldn't get any, well, crazier, it did on Tuesday.

Many investment pros already were aghast at the huge jumps in recent weeks made by big-name Internet-related stocks with little or no profit, such as Yahoo and Amazon.com. But at least with those stocks, Internet bulls could defend their enthusiasm by noting that the firms are industry leaders with the best prospects for success.

On Tuesday, however, smaller and far riskier stocks skyrocketed on enormous share volume as investors lunged at virtually any and every Internet name.

A few examples: A day after announcing a deal with America Online, stock research company Market Guide almost tripled in price. It closed at $23 after a two-day run-up from $3. Meanwhile, 7th Level surged more than fivefold to $9.25 on news that its animation technology will be distributed by an Internet data provider.

It didn't stop there. In a sign of how frenzied the buying has become, obscure penny stocks took off without releasing any news. Internet commerce play First Virtual Holdings more than doubled to $1.75 and Santa Ana-based Alpha Microsystems, a software firm, climbed 55% to $2.81.

In other cases, the stock warrants of some Internet companies zoomed. A warrant gives a holder the right to buy stock at a specified price in the future. Apparently, some investors didn't want to pay rising prices for the stocks themselves so they latched onto lower-priced warrants. For example, shares of Online System Services rose a relatively modest 21% to $14.31, but its warrants did twice as well, closing up 42% at $3.38.

This mania kicked into overdrive with K-Tel International's surge last week on news that it would sell its recorded music over the Net.

Instances like this are what Wall Streeters refer to as "blowoffs," as small, unproven stocks rise in a speculative mania. But because the rallies are based more on hype than company fundamentals, the excitement sooner or later reverses and leaves many investors with losses.

"It'll end very badly with a big bust," said Michael Murphy, editor of the California Technology Stock Letter in Half Moon Bay, Calif.

Even more worrisome, small investors are likely to be significant players in the Internet rally. Flush with big profits from the bull market, many people now figure they can make money easily in this market. There's "a lot of 'chat room' investing" going on, said John Force, manager of the PBHG Technology and Communications fund.

To understand the danger to individual investors, consider how and why sector blowoffs occur.

When a sector notches a huge advance, investors who have been on the sidelines suddenly decide to get involved. Instead of buying better-known stocks that have already moved, they dash into smaller stocks.

Those small-capitalization issues can rise quickly for several reasons. Typically, they have far fewer shares outstanding than larger stocks. So it takes very little buying pressure to boost them. What's more, many individual investors place "market" orders to buy shares. These are requests to buy a stock at its current market price, whatever that may be. Brokerages, faced with a surfeit of such orders, fill them at successively higher prices.

"By the time you get to the last [market order], the stock can be 50% higher than it was 60 seconds earlier," said David Simons, managing director of Digital Video Investments, an institutional research firm in New York.

Individuals might do better to place "limit" orders, which specify an exact price at which they'll buy.

The other strategy individuals often try at times like this is shorting high-flying stocks.

The goal of shorting is to make money when a stock's price falls. An investor borrows shares from a brokerage, sells them in the open market and pockets the money. The hope is that the stock will then fall so the borrowed shares can be replaced at lower prices.

But individuals trying to short small, fast-rising stocks may fall into a classic Wall Street trap.

Shorting is exactly what brokerage firms expect individuals to do with hot sectors. When small investors short stocks, they often put in stop-loss orders at the same time. That tells a broker to close out the transaction if the stock keeps rising, rather than declining as the investor hoped. A stop-loss is aimed at limiting losses on a wrong-way bet.

Brokerages, of course, know the prices at which stop-losses have been set, Simons said. If the firms themselves have positions in the stocks, they may help boost prices enough to trigger stop-loss orders. That creates what's known as a short squeeze: To close out their bets, investors must buy shares to replace the ones they borrowed--sending the stocks even higher.

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