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Bull Market: Where's Heads and Tails?

Internet Frenzy: Someone Is Going to Get Burned

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 But at least with those stocks, Internet bulls could defend their enthusiasm by pointing out that the companies 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 character-animation software will be distributed by a network and data company.

But 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 while Santa Ana-based Alpha Microsystems, a software firm, climbed 55% to $2.81.

In other cases, the stock warrants of some Internet companies took off. 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.

Instances like this are what Wall Streeters refer to as "blowoffs," as small and unproven stocks rise in a speculative orgy. But because the rallies are based more on hype than the underlying fundamentals of the companies, the mania sooner or later reverses course 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, individual investors are likely 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 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 would 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 price falls. An investor borrows shares, 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. That tells a broker to close them out of 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 find shares to replace the ones they borrowed and must pay up to do so. That just sends the stocks even higher.

"There are ranks of people out there who feel rich because of the bull market who are willing to take a flier on shorting these things," Simons said. "There are always people who figure, 'How can I lose by shorting?' Well, you can lose, because you play right into the hands of the pros."



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