How to Play the Bounce Today

You may not know Steve Galbraith's work. He's the Sanford C. Bernstein analyst who confirmed for me that, when it comes to the Nasdaq, the individual is in charge. His breakthrough work on margin and the individual is what allowed me to suggest that maybe it was time to take something off the table before things got too rough.

I gave my brokerage speech at Columbia University's business school last night, and I thanked him in front of his class, but not in front of you readers. Steve is perhaps the only person I have worked with who understands completely how much margin has infected the system. That pejorative verb is right; the first two months of this year saw a level of borrowing that made me understand that things can't last. There had to be a margin-call wipeout.

Some of his students were skeptical about how important the individual has become in determining prices on the Nasdaq (as opposed to on the New York Stock Exchange where the supply-demand/leveraged-nonleveraged quotient hasn't changed much over the years). Others were skeptical that the individual has become levered to the point that Galbraith asserts.

But yesterday's market, where account after account was closed out in a desperate attempt by brokerages to get their money back before the Redbacks (RBAK Quote) and the Vignettes (VIGN Quote) dissolved into oblivion, showed me the incredible rollback effect once margin is overabused.

Nobody wants to sell stocks down 50 or 60 points -- except those who have lent money to others betting that these stocks will go higher.

It is through Steve's help that I now ask, before every single buy decision, "How is the shareholder base here? Is it margined? Is it eroding? Are the insiders and the venture capitalists bailing? Is there a ton of supply that will soon overwhelm the margined demand?"

I wish it were as simple as just asking, "How is the company doing?" But Galbraith's work showed me that the single most important factor in assessing a stock right now is whether the individual has borrowed brokerage house money to stay long an extended stock.

Of course, there are no set, published figures about this stuff. But we can tell from trading patterns during the day which stocks are most vulnerable to the margin clerk: stocks that have come public in the last 18 months with a small float that also have, in the last three months, expanded dramatically via the expiration of lockups and issuance of secondaries. (ipoPros.com has the list; check it out.)

Stocks that fit these criteria will get sold on bounces even as we buy other stocks and keep them. These stocks are creatures of the dog that wagged the tail, Galbraith's term for the retail investor who, in the last year, took control of the Nasdaq.

Now that the dog has fleas, courtesy of excessive use of margin, can you afford to lie down in bed with him? Galbraith's work says no. It's something to think about as you play the bounce today.