It's always something. Just when it seemed the stock market had become a one-way street and a sure way to get rich quick (as in, really, really quick!) was to buy speculative issues in quantum, nuclear, rare earths, etc., "something" came out of the woodwork to spoil the fun.

To be sure, things had become more than a little frothy in what many refer to as "spec tech." As the moniker suggests, the companies in this space have very promising ideas and their futures look extremely bright. However, generally speaking, in this space, company earnings at the present time are either nonexistent or sketchy at best. But with so many investors looking ahead to the promise of the future, these issues have attracted a LOT of attention recently, leaving traditional valuations in the redonkulous category.

While the bulls argue that current levels are justified because of the massive upside potential in the arena, the bottom line is this is what speculative investing is all about. And who doesn't like to see their holdings double or even triple in a matter of weeks?

The problem is with no real earnings to measure against, "value" lies in the eyes of the beholder. So, when the crowd falls in love with an idea such as quantum computing, the new nuclear game, or rare earths, insane gains can occur - very quickly. And with holders enjoying the ride, common sense can go out the window. Which, of course, leaves these issues vulnerable to "something" bad happening.

This "something" doesn't have to be company- or industry-specific. No, it really can be anything that causes investors to stop and think. I.E. "something" that reminds traders that taking some profits on massive gains isn't a bad thing. And when "something" comes along to create such a pause or a rethink, everybody does some selling - all at the same time, of course.

Such is the game with speculative investing. You definitely want to be "early" to these issues whenever possible - if for no other reason so that you can sit through the inevitable potholes and/or bumps in the road that usually accompany such areas of the market.

The "Something" is Credit

The "something" this time around appears to be the higher risk areas of the credit market. Cutting to the chase, investors have been treated to a couple high profile bankruptcies. Namely auto parts First Brands and subprime auto loan provider Tricolor Holdings.

Not surprisingly, the sudden collapse of these two company created a case of Deja vu all over again for traders in the high yield markets. Thus, a case of, sell first, and ask questions later took hold in the junk arena. And for a while, nobody outside of these niche traders seemed to care.

But then Jaime Dimon came out and started talking about "cockroaches" in the credit markets and soon thereafter, a couple regional banks (specifically Zion and Western Alliance) announced some "problem" loans. Uh oh.

Soon thereafter, traders of all shapes and sizes started fretting about a 2008-style meltdown. As such, the fast money started selling anything in the more speculative arena. Why? Because smaller companies are more dependent on credit and outside funding. Thus, worries about the availability of that credit/funding took center stage.

Cooler Heads Prevail (So Far)

Upon further review, it appears that the bad loans in the regional banks that sparked last week's selling, were (a) quite small in nature (in the millions, not billions) and (b) limited to the parties involved. In other words, so far at least, this appears to be a bank/company-specific problem and NOT something systemic to the industry.

With that said, however, it is worth remembering that just about every major collapse in financial history starts off being "company specific." Until, of course, it wasn't. Recall that Lehman said everything would be fine on the Friday before they had to shut the doors on Monday.

As such, this is "something" that definitely warrants our attention going forward. In short, we need to know whether or not the recent credit/loan problems are truly company specific. In other words, we need to be on the lookout for Mr. Dimon's cockroaches.

What About Spec?

As for the aforementioned "spectech" areas, the recent bout of credit indigestion did indeed cause some "whoosh" selling. And given the degree to which these issues have run, such events can certainly be unpleasant.

However, these pullbacks - which tend to be in the 30% or higher range - are definitely part of this game. And if you don't understand this simple fact, you probably shouldn't be investing in such future technology.

This is also why position-sizing and rebalancing is an important part of investing. For example, if a position doubles or triples in a short period of time, common sense dictates that "right-sizing" the position is prudent. Sure, taking some chips off the table into a spike higher can feel crummy if the joyride to the upside continues.

But then again, maintaining appropriate position sizes can also help one sit through the volatility that is associated with investing in speculative issues.

Don't get me wrong, I'm not talking about trying to "time" tops and bottoms. No, this is a fool's errand for sure. However, experience teaches us that when things get frothy, it can be helpful to think prudently and take a little off. Or maybe hedge. Or raise a little cash. Or maybe all of the above. Because the bottom line is "something" will come out of the woodwork, at some point, to interrupt the fun.

Thought for the Day:

Never let success go to your head or defeat into your heart...

Wishing you green screens and all the best for a great day,

David D. Moenning
Founder, Chief Investment Officer
Heritage Capital Research, a Registered Investment Advisor

Disclosures

At the time of publication, Mr. Moenning held long positions in the following securities mentioned: None - Note that positions may change at any time.

NOT INDIVIDUAL INVESTMENT ADVICE. IMPORTANT FURTHER DISCLOSURES