2011—Year of the Bear for
Reverse-merger Stocks

Why 2011 was a terrible year for reverse-merger stocks. Market professionals around the world have been closely tracking developments in Europe and watching how the euro currency is behaving. Since May 2011, the euro has declined around 9.4% against the U.S. dollar. This weakness occurred due to certain events that took place in Europe, especially in the PIIGS countries, which led to rating downgrades in these countries.

The global economy is facing another possible bear market and the outlook is dependent on the economic releases and the actions of the policymakers. Recently, major central banks globally—the U.S. Federal Reserve, the Bank of Canada, the Bank of England, the Bank of Japan, the European Central Bank, and the Swiss National Bank—took coordinated actions on November 30, 2011, to increase dollar liquidity for European banks. This move didn’t mean any kind of bailout for Europe; neither does it better the credit quality of Europe, but it resulted in a strong positive reaction in the global stock markets to avert a bear market. This can surely be taken as an effort to shore up the global economy.

Another positive surprise came from China after it cut its bank reserve ratio to increase the cash supply for its banks. These actions are likely to boost the investor’s risk appetite and thus push buying towards stocks to try to get Chinese stocks out of their bear market.

Talking about reverse mergers, the year 2011 has turned out to be major bear market for investors in such stocks, as events like the SEC recommending a  cautious stance for such investors, the NASDAQ’s proposal of new listing requirements, and Moody’s “red flags” report on China-based companies have placed immense pressure on this asset category.

A large list of accounting fraud accusations as well as the questionable practice of performing reverse mergers with shell companies to get a listing on a U.S. exchange have made foreign investors more hesitant toward buying such stocks. These events have led to a slowdown in the deal activity in reverse mergers and the bear market in this area.

The bear market in reverse-merger stocks is evident from the poor performance of the Bloomberg Chinese Reverse Mergers Index (CHINARTO Index), which is a market capitalization weighted index that tracks China-based companies that trade on U.S. exchanges following reverse mergers. As of November 30, 2011, a bear market is firmly in place, with the index down 57.8% since December 2010 compared to the S&P Index decline of 12.6% during the same period.

According to the latest Reverse Merger Report, the third quarter witnessed the lowest quarterly number of reverse mergers since 2003. But, in spite of the current turbulent market environment, there are some positive signs that have emerged, which could be a catalyst to trade the better reverse-merger stocks regardless of the bear market.

Investors should be clear that the magnitude of profits gained from investing in reverse-merger stocks is likely to be less when compared to the returns from these comparative assets.

We are currently seeing a battle, as the S&P 500 tries to hold at its 50-day moving average (MA), but the real problem will be resistance at the 200-day MA, which you can read about in Market Risk: Why Upside Moves Will Not Be Easy.