Just because it's cheap

Trash dash: The biggest US winners in the silly-season market rally have been shares of shaky companies. The rationale is that some firms offer a leveraged bet on economic recovery. Investors have taken to the idea with gusto. Bank of America, Citigroup, Fannie Mae and Freddie Mac have accounted for more than 40 per cent of all trading on the New York Stock Exchange so far this week. Yet Wall Street, as it always does, appears to be taking the idea too far.

The performance of many crisis casualties has been stunning. Citi and BofA have risen about four-fold and six-fold, respectively, off their lows. This isn’t surprising based on history - just look at the stunning recovery Citi made in the early 1990s. Financial shares are heavily geared to the economy. A recovery means fewer borrowers default, so forecasts get less bad quickly. When banks step away from the brink, investors reduce the discount to book values.

The case for Fannie and Freddie appears more dubious. Shares of both have gained more than three-fold in August. The real-estate market is perking up - home prices actually rose in July, according to the S&P/Case-Shiller Index. But these two companies were effectively nationalised in November. Moreover, the two would need huge capital injections to reach adequate levels: the firms have $5.4 trillion of combined investments and guarantees on their books.

And then there’s the truly ridiculous. Internet telephony firm Vonage has seen its stock surge more than four-fold since August 24 on talk of an application for the iPhone. This is odd given Apple’s partner, AT&T, presumably wouldn’t be happy about the idea. What's more, Vonage sells cut-rate telecom service, so, unlike banks, isn’t a natural play on economic recovery.

Furthermore, Vonage’s revenue is shrinking as customers find cheaper options. Its assets are worth less than its liabilities. Short-covering doesn't even look to blame. This simply seems like a case of aimless investor bargain hunting - because Vonage shares look "cheap" at less than $3 apiece.

The dash for trash is on. But make no mistake - a lot of investors will be left holding garbage.