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How to Profit From a Stock That's Plunging

On Aug. 28, the shares of four small and medium-size companies plunged more than 20% in a single day on volume at least seven times greater than average.

In the bull market, traders became accustomed to looking at such moves as buying opportunities, playing for a reversal as the cavalry of growth-fund managers rode in to defend their honor. But this is not a bull market, and for the most part, moves of that magnitude have been a red flag of much worse to come. They have become red meat, to be more specific, for the growing legions of quick-trigger short-sellers ready to blast anything that wavers to smithereens.


Four Plungers on Aug. 28
These stocks fell hard on strong volume
Company % Change Aug. 28 Close Aug. 28 Volume Volume vs. Year Average Market Cap
j2 Global Communications (JCOM) -21.58% $18.71 2.16 million 28.9x $202 million
HealthSouth (HRC) -24.74 5.05 42.16 million 15.2x $2 billion
Semtech (SMTC) -25.74 14.05 12.33 million 9.6x $1.1 billion
Culp (CFI) -35.69 8.65 507,700 7.7x $99 million

The four stocks listed in the above table have little in common on the surface. One, j2 Global Communications (JCOM), offers Web-based communications services. Another, HealthSouth (HRC), runs hospitals. The third, Semtech (SMTC), makes semiconductors. The fourth, Culp (CFI), makes fabric for furniture. But the undercurrent linking them is an extreme imbalance of information among market players about the stocks' future. One side, either the bulls or bears, suddenly has become radically wrong about the prospects for the stock.

My research shows that in the past two years, this sort of one-day imbalance very often leads to further declines of a similar magnitude. In other words, once a stock plummets, it's likely to plummet again.

From March 2000 through the end of last month, 564 stocks sank by more than 30% in a single day on at least 300,000 shares traded and ended at a price greater than $7, according to research performed for me by Tony Kolton of Logical Information Machines. A day later, the prices on average were unchanged from their final price on the plunge day, but a month later the median stock was down 4%, six months later the median stock was down 23%, and 12 months later the median stock was down 51%.

Of the 437 stocks that have completed 12 months of trading since their plunge date and are still trading, 76% are down in price. (The results would probably be worse if all the 30% plungers that went out of business and were delisted were included.) See the table below for details. If you'd like a spreadsheet with all the data, write me at jmarkman@microsoft.com , and put "Plungers" in the subject line.


What Happens Next?
That first drop can be only the beginning
Change After? One Day Change After? One Month Change After? Six Months Change After? 12 Months
Median 0.00% -4% -23.3% -51.5%
Number of Stocks Up 287 260 154 103
Number of Stocks Down 277 311 336 334
Percentage of Stocks Down 49% 54% 69% 76%
Data: Logical Information Machines. Dates: March 2000 through August 2002

Playing the Plunge

The follow-up drop typically comes after a few days or weeks of sorting out, as it becomes increasingly clear that bears had a clearer view of the prospects for the stock than bulls, who were guided by a set of false beliefs.

When a stock dives 30% in a single day, after all, bulls on the stock often suffer from denial at first. But pretty quickly, they figure out that they've been misled. Then they become disgusted and get ready to walk away. Fear becomes overwhelming as they question all their assumptions. As stocks enter a period of parabolic decline on increasing volume, institutional investors seem to jump out of the stock at greater and greater volume.

"I like to see the stock sink below its 50-day moving average on this move," said George Fontanills, a Florida trader who likes this sort of setup for short sales. "You are looking for signs of fear, of desperation, of giving up," says Fontanills, who also runs the Web site Optionetics.com. "If you watch a stock during one of these moves with five-minute tick bars during the day, you can just feel how support levels crumble faster and faster as the stock sinks. You can keep following the stock lower until you feel the volume dry up or decrease to the point that sellers are no longer the dominant force in the move, that they have become less aggressive and reached an equilibrium or accommodation with buyers."

Essentially, the 30% down move tells the bulls that someone has information that they don't have, and that they should now fear more skeletons in the company's closet.

Here's how Fontanills plays such situations. First, he determines whether the news that caused the plunge has a lasting quality that will cause the company to face a bombardment of bad vibes in the media. A revelation of accounting irregularities, for example, will potentially last longer than just a quarterly earnings disappointment. If the plunge looks to have staying power, Fontanills typically waits a few days or more for a mild rebound, then buys out-of-the-money put options that expire three months to 12 months out. Next, he says, "we wait patiently for the stock to do what it's destined to do, which is fall apart."

He likes shares of companies about which there is a lot of uncertainty, pulling the stock in both directions. Wild oscillations reflexively create even more uncertainty, often persuading more shareholders holding long positions to panic.

Case Study: Tyco

A good example: Tyco International (TYC), which came under unrelenting scrutiny for its accounting and for the practices of its executives and directors in 2002. The jolt in the company's stock was a big surprise to most market players, because shares hit an all-time high around $63 in early 2001 and revisited that level in December 2001. At the time, it was one of the 20 most widely held stocks on the New York Stock Exchange. Its acquisition strategy had become a favorite of growth-stock managers who had few good themes to play. Shares were remarkably nonvolatile during this time, never moving more than 7% in a day in 2001, even in the wake of the terror attacks.

In mid-January 2002, however, the first crack in Tyco's story appeared when it announced that it would split up into four companies to make its accounting easier for analysts and shareholders to understand. That news was greeted with angst by investors and a mildly negative one-day response. But two weeks later, on Jan. 29, 2002, the company slid $8.35, or 20%, to $33.65 in a single day of massive volume: 170 million shares. The catalyst was an announcement that it had richly compensated one of its directors for arranging the acquisition of CIT Group, a company in which the director held stock.

The news clearly shocked the company's partisans, many of whom were still smarting over the conflicts of interest that emerged in the wake of Enron's collapse. Tyco shares rebounded modestly over the next three trading days. But the strategy of buying puts on a 20% or 30% decline on large volume would have been correct, as the first high-volatility day presaged more to come. As the company denied anything was wrong, bears came to believe that an Enron-like set of disclosures was about to begin, and they pressed their advantage.

A week later Tyco went on to post -16% and -23% sessions back-to-back, falling to $23.10. For the next couple of months, the stock slowly worked its way back to the low $30s. But many traders came to believe that the -20%, high-volume day signaled a change not just in price trend but also in "opinion trend" about the stock. And they didn't need to wait long to be rewarded for that interpretation.

In late April, further revelations resulted in three days of -19%, -4% and -14% as the stock sank further, to $17. The cycle of reconciliation between bulls and bears then began anew, as the stock worked its way back to the mid-$20s before another disclosure sent shares reeling down 27% on June 3 to $16.05, followed by two more back-to-back days of -16% and -31% on June 6 and June 7, to $10.10. Once again, the cycle of reconciliation between bull and bear points of view recommenced, and shares drifted languidly back to $17 by late August.

Crunching Numbers

To study the effect of -20% and -30% moves in any stock that captures your interest, you must learn to export price data to a spreadsheet program like Microsoft Excel. It's easily done from charts on MSN Money. Start with a one-year chart by clicking Period on the chart's top menu bar and choosing "1 Year" from the fly-out menu that appears. Then click "File" on the top menu bar and choose "Export Data." If you have Excel on your computer, the application will open, and the daily high, low, close and volume data will automatically appear on a new sheet.

Next, you need to prepare the sheet for your calculation of daily percent change. First, eliminate all blank rows where market holidays appear. You can either delete these rows manually or use Excel's AutoFilter tool on one of the columns -- Column E, for instance. Once you have Column E selected, click "Data" on the Excel toolbar, select "Filter" and then "AutoFilter," and choose "Blanks" from the list at the top of Column E (click on the arrow in the column header to see the list). When all blanks are showing, delete those rows. Next, click on the arrow again and choose All, to reveal all the data rows again. Now go to the bottom of the first open column and insert a formula that calculates the percent change. Then copy that formula up to the top. To spot the -20% rows more easily, choose Format/Conditional Formatting on the spreadsheet's top menu row and ask the software to turn all rows with less than -20% red.

That's it. Now eyeball the list or do further calculations to see what has happened in that stock after its 20% and 30% declines.

The Top Plunge Pick

As for the current group of four stocks, the one with the best potential for further downside, in my opinion, is j2 Global Communications, which does not appear to deserve to be one of the few holdouts of the great dot-com bust. The company, which provides Web-based fax and teleconference services, has repeatedly reported higher and higher revenue during a time when all its rivals and vendors are reporting poor results.

It strains credibility that one telecom-complex company, based on Hollywood Boulevard in Hollywood, Calif., could be successful, and all others flop. Insiders bought shares heavily at $4 in early January, but since spring, all insider activity has been sales around $19 to $21. The trailing price-to-sales multiple is a lofty 5.5. Technically, the stock had hugged its 50-day moving average en route to a parabolic advance that ended on Aug. 26, but it fell through that level on Thursday last week, and the next stop, if you believe in following such things, would be its 200-day moving average -- another 50% decline away at $9.85.

j2 Communications and Culp do not have options, but I will track far-month, out-of-the-money puts on the other two companies that fell at least 20% on Aug. 27. They are: HealthSouth 2003 $5 puts, $1.35 asked on Aug. 29; and Semtech March 2003 $12.50 puts, $3.20 asked on Aug. 29.

While Jon Markman cannot provide personalized investment advice or recommendations, he invites you to send comments on his column to 7jonmail@microsoft.com. At the time of publication, he did not own or control shares in any equities mentioned in this column.

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