Have you ever come across a market situation where the price of a single stock keeps increasing while rest of the stocks are driven down dramatically. It. Is hard to think of reasons why such market pattern comes into play, but this is what precisely happened over a 100 years ago in the US.
This is what happened back in April – May 1901. The shares of railroad companies were in great demand back then (as railroads were like the hot technology companies in that era of industrialization). One particular company, The Northern Pacific Railroad, caught the fancy of two financiers – James Hill and Harriman. Both of them were interested in acquiring a controlling stake in the railroad. Hill was acting through his investment banker J.P. Morgan while Kuhn Loeb was representing Harriman.
Hill and Morgan owned a non-controlling stake in the railroad while Harriman was gradually increasing his stake in the company by buying shares in the market. In 1901, it was possible to acquire a controlling stake in a company without making a public disclosure.
Despite mediocre results, the stock price increased by 25% in April 1901. Consequently the short interest in the stock increased as some market players perceived the stock to be overvalued.
For the uninitiated, a short position in a stock means selling the stock one does not own by borrowing it from another investor. A short position makes money if the stock price declines relative to the level at which the short position was initiated. When the stock price declines, the stock is purchased at a relatively lower price in the market and is delivered to the lender of the stock.
So a short position is initiated in anticipation of a decline in stock price, just as a long position is taken in anticipation of an increase in stock prices. The key risk to a short position is an increase in
the stock price which can lead to unlimited losses as the stock price continues to increase. In a long position, the maximum loss is limited to the initial investment but in a short position the losses can be infinite unless the position is closed out.
Through the first week of May 1901, the stock price continued its upward march and slowly it became clear to the market that a takeover battle between the two financiers is raging on. Hill & Morgan attempt to corner all outstanding shares in the market and the supply of shares rapidly dwindled in the market as it becomes a one sided market (only buyers and no sellers).
Investors with a short position are now willing to pay any price for covering their short positions and the price of the stock touches $1000 (from around $140 a few days earlier). To fund their short cover (close out the short position by buying the Northern Railroad stock), traders were now forced to liquidate their other stock holdings and this triggers a sharp correction in these stock prices. As the news spreads about what’s going on in the railroad counter, rumours start to spread about similar situations in other stocks and very soon the market correction spreads like wild fire.
This is a unique market situation – one stock going to the moon while the rest of the market is going down. Some stocks decline by as much as 60%, totally misaligned with the fundamental economics of that business. Such market situations present once- in-a-lifetime opportunities for smart investors who can stay detached from the market mania and are able to distinguish between the fundamental value of a stock and the price accorded to it by the market. Needless to add, one should have enough dry powder (surplus cash) to exploit these profitable opportunities.
Market regulators have learned from such episodes and have put in place checks and balances to prevent such market manipulations. But as they say, regulation is always a catch up game. Despite prudent market regulation, panic selling triggered
by the need to cover portfolio losses is a clear and present danger that stares at the market even now. The selling contagion witnessed during the global financial crisis in 2008 is one such example.
The important lesson to take away is – sporadically, market mechanisms (the way the market is structured and securities are traded) create a divergence between the fundamental value of a stock and its price in the market. Patient and disciplined investors can profitably exploit such opportunities.