Yesterday, we began a discussion of the ways in which unscrupulous players can cheat investors out of their money. Unfortunately, it was only the beginning of the story, and today we will discuss still more means of manipulating a stock. Where the first day's discussion focused on activities that are clearly illegal, today's discussion moves toward sneakier means of scamming investors out of their money.
Pump & dump (and short & distort)
Pump & dump scams are also a classic manipulation play. While there are different arrangements from scam to scam, the basic idea is to tout the supposed prospects of a company in an attempt to lure in unsuspecting investors that will push up the price. As the price goes up, the original scammers sell their stock to the new blood and book a nice profit.
Sometimes the company itself engages in the promotion, and other times the insiders hire promoters to pump the stock. In any case, you begin to see streams of press releases and/or "research reports" from companies that you never before heard of. There's a remarkable similarity between them (after all, promoters know the buzzwords that will draw in the rubes) -- new technologies that will revolutionize an industry, imminent cures for dread diseases, and so on.
Of course, none of the garbage is true, and once the insiders have sold out, the hype machine shuts off. Once the hype dries up and there are no new "investors" (and I use that term very loosely), the accumulation pressure evaporates, the stock crashes, volume dries up, and investors go away licking their wounds and wondering how they'll explain a $15,000 loss on Cool Research and Products (symbol: CRAP) to their spouses.
Pump & dump scams are overwhelmingly more common in the penny-stock world, so the first step in avoiding this type of manipulation is to avoid penny stocks in general. What are penny stocks? Although the traditional definition is "any stock trading below $1," a more helpful (though subjective) definition would be that a penny stock is a low-priced stock (say, $5 or below) that is not traded on the major exchanges such as the New York Stock Exchange, AMEX, or Nasdaq. There are plenty of frauds and scams among listed stocks (Enron, anyone?), but there are considerably more critical eyes looking at listed stocks, and the hype isn't usually as blatant.
The nature of the hype is also a good warning. Since these companies are overwhelmingly just junk (usually without products or real sales), the promotional material always talks about the fantastic future -- great new products about to be released, lucrative contracts with major companies just about to be announced, and so on. Ask any of these companies about what's going on today, and you'll get blank stares and quick attempts to turn the conversation to the glorious future.
I realize that nothing I say will dissuade penny-stock players from their favorite little game, but other investors should beware. Industry titans don't often grow from penny-stock seed, so if you're going to play the game, be sure you know what you're doing and what can happen to your darlings.
Rumors and trader tricks
Institutional managers and traders can also manipulate the price of stocks in subtle (and not-so-subtle) ways. Rumor-mongering is one great approach. Everybody loves rumors (anybody can get news, but only the "special" people hear the great rumors), and they spread like wildfire, often without much attempt made at confirming their accuracy.
Money managers can (and do) clearly use this to their advantage. Want to move a block of stock but don't want to get killed on the price? Spread a rumor to move the stock in your favor. If you want to buy some Nokia
Traders also get into the game, in most cases using individual investor psychology to their advantage. In simple terms, if you know the books that your opponent is reading from, you can position yourself to manipulate that for your own benefit.
For instance, many individual investors put in stop-loss orders with nice round numbers -- $40, $50, $100, etc. This has been true for so long that traders generally know that if a stock traded as high as $60 and is currently at $51, there's probably a boatload of orders waiting at $50. Spend a little money to shove a block of stock in the right direction, and the cascade of automated trades that follows can reap a tidy profit for the trader.
It's no different with some technical-analysis concepts as well. Everybody knows that a certain element of the investor population pays rapt attention to moving averages, trend lines, and the like. So, if you can find a relatively thinly traded stock trading near an important average line or trend line, you can sometimes goose it over the threshold and profit from technically oriented investors who rush to respond to the "technical breakdown/breakout." Take a look at a chart of Curtiss-Wright
The bad news here is that these attempts at manipulation are the hardest for investors to spot ahead of time and avoid. Quite frankly, there's not much that can be done if some hedge fund hedgehog wants to spread a rumor to buy your stock on the cheap. Rumors are part of the business, and they're almost impossible to track down. What's more, almost nobody is stupid enough to leave a paper trail that a prosecutor could exploit. (Not too many people keep records like "tried to illegally manipulate ABC Co. today.")
The good news is that most of these manipulation attempts are transitory. A stock might crack a psychologically significant number, trade down a couple of points, and then climb gradually back up. Rumors might buffet a stock, but sooner or later they're either proved or discredited. So as long as investors can maintain their long-term focus of owning quality companies for the long haul, some near-term turbulence caused by greedy and/or unscrupulous traders and managers won't amount to much in the end.
Of course, you can't talk about market manipulation without at least bringing up a fear harbored by a (hopefully) small minority of investors -- that the entire game is rigged. Conspiracy theories abound, and everyone from the Federal Reserve to the Masons to the International Brotherhood of Electrical Workers (just kidding) has been implicated as the "they" that are secretly pulling the strings behind the scenes.
The big run-up in tech stocks in the '90s? It was "they." The nasty crash that wiped out so much money among individual investors? "They" again. Sometimes the conspiracies are even a bit more elaborate -- such as the one I found online that suggests that "they" took their winnings from the late '90s tech run and used it to buy all sorts of mines, refineries, wells, and whatnot before instigating the recent commodity run.
"Balderdash" is the only word I can think of to describe these "theories" -- or at least it's the only word that my editors will let me use. If you really believe that nonsense, you need to do two things right away. First, sell all of your stocks (why play a rigged game?). Second, install heavy-duty padding on your walls and floors because you could really hurt yourself.
Manipulation is one of those nasty facts of life that we all have to deal with as investors. Just like littering and junk mail, it's a scourge that shows no signs of disappearing. Heck, I'd even go so far as to say that about 20 seconds after cavemen invented the first game, another caveman was working on a way to cheat the game.
The good news, though, is that even though manipulation has been part of the U.S. market from its outset, it hasn't prevented millions of people from making money through sound and well-reasoned investments. While this isn't a fail-safe plan to avoid all attempts to illegally separate you from your money, I do believe that most investors who exercise due diligence, due caution, and sound diversification have little to fear from the manipulators and well-dressed pickpockets of Wall Street.