how bad is it out there? real bad.

Last week, USA Today reported that an unbelievable 359 stocks on major exchanges are now below one dollar, up from 222 just two months ago. To put that number in perspective, twenty years ago only 60 stocks on major exchanges were “hat sized,” or trading for fractions of a buck. At the end of 2008, during the worst depths of the financial crisis, there were only 242 sub-$1 stocks:

It’s not just smaller companies that are struggling, either. Among the 3000 largest companies in the Russell index, 43 are below $1, vs. 13 at the start of the year and only two on January 1, 2015.

The performance of companies I have visited recently confirms this market reality. Over the last 26 months, I have interviewed 206 managements at their company headquarters. Most had market capitalizations in the $100M to $1 billion range at the time of my visits; none were in the S&P 500. Of those 206 companies, only 26 have a higher stock price today than the day I met their managements. Sixteen now trade below $1/share. Not surprisingly, a number of these underperformers are energy companies like Energy 21, Key Energy, Torchlight Energy, and Glori Energy. But plenty of companies from other sectors have tanked, as well. Notable losers include Bebe Stores, Vapor Corp (e-cigarettes? Are you kidding?), Speed Commerce, iPass, and Seattle biotech firms Oncothyreon and OncoGenex Pharmaceutical. I could go on (there are 170 more companies) but you get the idea.

What does all of this mean?

First, as I wrote a few weeks back, investors should avoid the temptation to buy ultra low priced stocks. Academic studies show they massively underperform the market indexes during most time periods. The vast majority of the 359 sub-$1 stocks listed in the USA Today piece will likely disappear altogether, while only a small percentage will rebound to $2 or more.

During three decades of managing money I have never bought a sub-$1 stock. But I have shorted many of these “single digit midgets,” with many filing bankruptcy no later than 12-18 months after I initiated my position. In the last few years shorts Dendreon, Valence, Anchor Bancorp, Furniture Brands, Miller Energy and Magnum Hunter Resources all dipped below a dollar and subsequently went to zero.

Second, the current penny stock bonanza proves that our already narrow market keeps getting narrower. While the S&P 500 rose 1 percent in 2015 and is down 5 percent in 2016, more stocks have declined than rallied during this period. Only a handful of stocks have significantly outperformed the indexes, including the much publicized “FANG” stocks, Facebook, Amazon, Netflix, and Google. At nearly $1.1 trillion in combined market cap, these four stocks now make up roughly six percent of the S&P 500. But while all have rapidly growing revenues, they sell at nosebleed price-to-revenues and price-to-earnings valuations. I think it is more likely these FANG stocks lose their ultra premium valuations than zoom higher, which would make this already bad market a full on disaster.

Finally, investors need to be extremely careful about buying into this downturn. Sure, there are a number of beaten down bargains in this market, but for every cheap or oversold stock, many more will trade sideways at best and could very well wind up a whole lot lower. In this grim climate, retail investors would be well-advised to stick with larger, profitable, dividend-paying Russell 1000 company stocks. When in doubt, pick Goliath.  Sadly, David is almost always a losing investment.

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