I Admit It – I missed the Boat on that One

During the recent turmoil in the financial sector, there were a few companies that were particularly hit hard with massive losses (we’re talking tens of billions of dollars here). As many of you probably already know, several of those companies required huge cash infusions from the federal government to stay alive and prevent the entire financial system from collapsing. A crashing stock price was a natural consequence of these problems. Investors don’t like it when their companies need bailouts from the government.

This is exactly what happened to two of the worst culprits of the financial crisis – AIG and Citigroup. I’ve mentioned both companies several times in previous posts as some of the most severely affected names in the crisis. AIG, one of the world’s biggest insurance companies, was impacted through selling insurance policies against the very mortgage backed securities that caused the crisis. When those securities began to wither in value, it was left with billions in claims obligations from banks that it could ill afford. Citi, on the other hand, became deeply involved in the selling of mortgage backed securities. The company eventually became a hugely complex and slow-to-react institution that was unable to handle the downturn in the very products it sold.

Eventually the stock of both companies fell…and they fell hard. We’re talking declines of 95%+ from their highs. At one point, Citi was trading under $1 a share! But somehow, some way, after billions of dollars of bailout money from Uncle Sam, both companies were able to survive the crisis.

Time for the Runup

So at the height of the crisis earlier this year, both Citi and AIG were down in the dumps in terms of stock price. Eventually, after seeing some stabilization in the market, they were able to crawl back a few dollars per share. Citi went from its lows of $0.90 a share to almost $3. That’s a gain of over 300%, and the brave few that chose to invest during that time made out like bandits!

It was around that time that certain family members of mine encouraged me to buy Citi stock. Their logic was that since the company wasn’t going bankrupt, how much lower could the stock go? I thought otherwise. Forever the skeptic on huge runups that companies like this had, my thoughts were the following:

1. The government had HUGE stakes in these companies now (that’s right, fellow tax payers, you own 30%+ of Citigroup right now). This creates a huge conflict of interest for the company that many of Citi’s biggest competitors didn’t have.
2. Citi had to issue massive sums of new stock to stay alive during the crisis - meaning that the stock was so diluted, $3 could very well be a fair value for it, even if $30 was fair before.
3. This one is just common sense, the stock had already gone up 300%! How much more running room could it have?

Because of these (what I thought were logical) reasons, I refused to play with fire and buy Citi stock. Low and behold, the stock has continued to skyrocket since hitting $3 a share. In fact, it has gone up almost another 100% and is hovering around $6 a share.

Why Was I so Wrong?

OK, so I made a mistake. My family was on to something, and I missed an opportunity for an easy 100% gain. But, to me, the more important thing here is to understand where I was wrong. What did I miss about Citi that has caused the stock to go up six fold in a matter of months.

Well, what I was missing was what’s known as the ‘Short Squeeze’. This highly technical and not so much fundamental concept is when traders who are shorting the stock are forced to buy the stock in order to cover their short positions, thereby bidding up the price.

I’ve talked about shorting a few times before, but I’ll do a quick refresher. Shorting is basically betting that a stock will go down. You accomplish it by borrowing the stock from your broker and selling it. You then hope the stock will go down so you can buy it back later at a lower price. However, if the stock goes up, traders often have to buy the stock anyway to pay back their brokers and cover their losses (this is called ‘covering’ a short position). Sometimes when a stock is going up rapidly, there is a large amount of short covering that occurs, thereby driving up the stock price even higher due to the buying that must be done for the short covering. This is eventually known as a ‘short squeeze’, because the shorts are being ‘squeezed’ out of the stock and the stock price is vaulting even higher.

Well, during the worst times of the market, there was HUGE amounts of short positions on both Citi and AIG. At one point, Citi’s short ratio was 18% of float. That means that 18% of Citi’s total stock was being held as a short position – an absolutely massive amount.

Well, with that much short interest being squeezed out of the market after it became apparent that Citi and AIG would survive the downturn, the stock just rocketed up. And I totally underestimated just how short the market was on these stocks. The past few months have been a massive short squeeze for both Citi and AIG. Although there are also some more fundamental reasons for the runup, they’re few and far between.

My Lesson

So, my parents were right, and I was wrong (isn’t the first time). Citi was still a good buy at $3 a share because the short squeeze was very much still in progress. Unwinding 18% of short interest just takes some time. However, another interesting aspect here is that, because the runup in the stock is to a large extent a short squeeze, it’s not driven by fundamentals. This could very much indicate that the price is now artificially inflated and will eventually have to correct. Where that will be, I’m not sure. But maybe it’s time to actually short Citi and AIG….?

Questions/Comments/Feedback?
Please don’t hesitate to let me know of any questions or comments you have about this post or any other. If you want me to write about something else investing related, do let me know!

The Standard Disclaimer:

The stuff I just wrote above is my opinion and my opinion only. Please do not take it as fact. Perform all necessary research and analysis prior to acting on anything I've said above. This includes consulting with a financial advisor.