On November 18, 2015, KaloBios Pharmaceuticals Inc. (KBIOQ) announced that Martin Shkreli and a consortium of investors had acquired more than 50% of its outstanding shares.
The stock, which had closed at $2.07 that day, traded above $10 the day after the announcement. The next day, shares rose above $23 and closed at $18.45. The following Monday, the stock miraculously traded for over $45 per share.
In just six trading days, the market cap of KaloBios had risen from under $4 million to over $160 million. It was a blatant example of market inefficiency. But what could cause such an irrational spike?
The answer is an acute “short squeeze.”
A sharp rally in the price of a stock puts pressure on short sellers, who are betting the stock will fall. They may feel the need (or be forced) to close out their short sales by buying the stock.
The buying pressure from this short covering causes the stock to move higher, compelling even more traders to cover their shorts.
Over the past month, we’ve seen a bevy of short squeezes as the U.S. stock market has bounced along with the price of crude oil. These squeezes haven’t been as spectacular as the above example, but judging by how heavily shorted some of these stocks are, they’ve been very painful for the short sellers, nonetheless.
The following table shows a few of the largest squeezes:
The short interest ratio (SIR) is the number of shares sold short divided by the average daily trading volume.
The average SIR for S&P 500 constituents is 3.3 times. At 9.5 times, the average SIR for these stocks is much higher – and for good reason.
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The risk of bankruptcy is very high for the companies on this list. Thus, they all have Standard & Poor’s credit ratings of CCC+ or lower.
Two of the companies are already in selective default (SD). Others will eventually join them. Many of the stocks on this list will end up worthless.
Risks notwithstanding, the short squeezes have been eye watering. Chesapeake Energy Corp. (CHK) shot up 208%. Linn Energy LLC (LINE) annihilated the shorts with a 398% maximum gain over the past month.
In spite of these equity gains, though, many of these companies won’t have fairytale endings.
For example, the 6% bonds due 11/15/2018 for Peabody Energy Corp. (BTU) have rallied, but they’re still trading around $7 ($100 par). The bond market is saying that there won’t be much recovery for senior unsecured creditors, which means that equity shareholders will be left with approximately zero.
The equity shareholders of the companies listed above are deluding themselves if they think the market cap reflects underlying fundamentals.
It’s important to recognize that a sharp rally in a stock doesn’t necessarily signal all is well. In most cases, these stocks aren’t rising from the ashes.
In fact, many of the companies with the most violent short squeezes will end up filing for bankruptcy, just as KaloBios had to do on December 30, 2015.
Safe (and high-yield) investing,
Alan Gula, CFA