Halloween is weeks away, but on Wall Street, it's already like a night of the living dead.
A number of the stocks at the center of the financial crisis that had been practically left for dead, including Lehman Bros., Washington Mutual (WaMu), American International Group (AIG), Fannie Mae and Freddie Mac, have posted strong percentage gains amid the stock market's recovery.
Lehman and WaMu, for instance, were booted from stock exchanges and filed for bankruptcy protection. Yet on the lightly regulated Pink Sheets markets, this year their stocks are up 500% and 1,050%, respectively.
Meanwhile, AIG, (AIG) Fannie(FNM) and Freddie(FRE) are still listed on the New York Stock Exchange, but must repay massive debts to the government. Even so, the shares are up 41%, 88% and 134%, respectively.
While it's impossible to lump all the stocks together, market observers say the jumps are a sign of rampant speculation and false hopes creeping into corners of the market that investors are better off avoiding.
"These gains are like the white static noise in the background that I tend to let go," says Robert Maltbie of research firm Singular Research. "People are playing these as the next penny stocks."
Fans of these stocks point to many reasons why the rallies are justifiable. But experts who study financial stocks and severe economic distress call the moves questionable and a case of dead stocks walking because:
•Severely battered stock prices magnify gains.
It's easy to be dazzled by the percentage gains in these stocks, but they're exaggerated by their low levels.
For instance, WaMu's more than 1,000% gain this year is just a function of the stock trading on the Pink Sheets for 23 cents, says George Putnam, publisher of The Turnaround Letter, who tracks corporate bankruptcies.
Some less-informed investors figure large stock moves by beaten-down stocks such as AIG and Fannie Mae that still are listed on major exchanges, mean firms such as Washington Mutual and Lehman that have filed for bankruptcy protection must surge, too.
"With stock prices so low, you have speculative buying," he says. Christopher Whalen, at banking research Institutional Risk Analytics, says, "It's not unusual for bankrupt things to flop on the floor of the boat for a while."
•Companies face pending legal action.
One big reason behind speculation in shares of WaMu is pending lawsuits. While the bank WaMu was sold to JPMorgan Chase for $1.9 billion in September 2008, the WaMu holding company is suing both the FDIC and JPMorgan to reclaim assets. JPMorgan declined to comment.
Speculating over whether the WaMu holding company will win the lawsuits and reclaim money is a popular pursuit for bulls on the stock. WaMu "is far from being a zombie stock," says Hans Brost, founder of Washington Mutual Equity Group, which operates a website to compile pending legal action with the company. Brost, who invested in WaMu stock after the JPMorgan deal, says he expects the courts to find the deal wasn't handled properly. "It was a travesty what happened to WaMu," he says. "There could be a significant recovery," he says. "I am betting on it."
•Artificial buying has a big impact.
Much of the buying in the zombie stocks is caused, ironically, by investors who bet against them, says Frederick Cannon, analyst at Keefe, Bruyette & Woods.
In something known as short covering, investors who made huge gains betting against these stocks must purchase them in order to realize their gains, he says.
Investors who lack sophistication may confuse short covering for real buying, he says. The stock in WaMu and Fannie Mae are worthless, yet traders are trying to make profits off daily moves, Cannon says. "You're getting guys in pajamas that are day trading this stuff," he says.
•There's a shortage of credible information.
As the companies faltered, the number of analysts following them has dropped off, too. Gradient Analytics' Donn Vickrey, who closely covered the financials of AIG, for instance, no longer follows the company or stock.
This void of information gives the speculators even more influence, thanks to online chat boards where they congregate.
Investors who are trading in the zombie stocks are forgetting the level of duress the financial system and the companies were under when the government took action, says Patricia McCoy, a law professor at the University of Connecticut. The moves taken by the government to save the system as these companies failed cost stockholders their stakes. "When the reckless loans crashed, shareholders should be wiped out," she says.
But the fact investors are willing to gamble on the stocks, and feel there might be a recovery, is a dramatic sign of the very nature of speculation. The run-up in the zombie stocks "shows hope springs eternal," McCoy says.
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