Separating Weak Holders From the Strong

A little more than a month ago, I wrote a column to help explain some of the differences between the market's strong and weak hands, and I received quite a response.

It's been a while since the story appeared, so here's a chart to clarify some of the ideas I put forth in it.

Table of Actions for Investors With Long Positions Consider four classes of investors and how they behave with respect to market action
Investor Action	Market Action
	Stock price goes down	Stock price goes up
More likely to hold	Valuation-sensitive and strong holders	Momentum investors and strong holders
More likely to sell	Momentum investors and weak holders	Valuation-sensitive and weak holders

To put it another way:

Weak holders play for small gains and losses.

Strong holders play for big gains, will ride out big losses and sometimes get killed with the firm.

Momentum investors require liquidity from the market and exacerbate price moves.

Valuation-sensitive (or mean-reverting) investors provide liquidity to the market. They hold or buy more when prices decline, and they sell when prices rise enough to hit their valuation targets. This category describes my normal posture in the market.

These four descriptions here are ideal investor types. Some investors and institutions fit only one of them, but many use a mix in their investing activity.

After Part 1 of this piece appeared, the most common reader question was, "How do you identify whether a stock's holders are weak or strong?" There's no simple answer, but I can offer a bevy of techniques and tools that I use for this purpose. Some require a good deal of experience and judgment; beginners can use others easily. Here are some tips to get you started:

Assess how the stock reacts to news.

Good news should make a stock go up, and bad news should make it go down. But we learn the most when the price reaction is different from what we expect. For example, if a stock refuses to go down much -- or even rises -- on significant bad news, then it has many strong holders. If it doesn't go up much -- or even falls -- on significant good news, then it has many weak holders.

Examine the short side.

Short-sellers are typically weak antiholders of a stock. The percentage of the float that is shorted will tell you how much of the stock is subject to buyback if the price rises significantly.

Now, short-selling is a double-edged sword. Although short-sellers have an impulse to buy back into strength, high short interest usually indicates problems at the company. If you encounter a heavily shorted stock, take a close look to see whether it's strictly a valuation issue or if something is fundamentally broken at the company on an accounting or operational basis. Short interest is available on Yahoo! Finance; here's an example of a heavily shorted stock, Phoenix (PNX - commentary - Cramer's Take).

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David J. Merkel, CFA, FSA, is a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. Previously, he managed corporate bonds for Dwight Asset Management. At time of publication, neither Merkel nor his fund had any positions in the securities mentioned in this column, though positions may change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While Merkel cannot provide investment advice or recommendations, he welcomes your feedback and invites you to send your comments to [e-mail].

Analyst Certification: All of the views expressed in the report accurately reflect the personal views of the research analyst about any and all of the subject securities or issuers. No part of the compensation of the research analyst named herein was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed by the research analyst in this report.

Merkel is employed by Hovde Capital Advisors LLC (the "firm"), a registered investment advisor with its principal office located in Washington, D.C. The Firm and/or its affiliates have or may have a long or short position or holding in the securities, options on securities, or other related investments of the issuers mentioned herein.