September 15, 2006

Professor: Beware spammed stock-touting schemes

Unsolicited e-mails touting the next red-hot stock, always couched in language that might make the unwary believe that this tip is just for them.

Laura Frieder of Purdue University's Krannert School of Management, has one word of advice: Delete.

"Most spam filters will pick up stock-touting schemes and put them in a junk mail folder or just reject them," said Frieder, an assistant professor of finance and co-author of a study that analyzed more than 75,000 "touts" drawn from 1.8 million reports of junk e-mail submitted to an Internet antispam newsgroup. "But spammers become more and more sophisticated, and these spam schemes rarely make money for anybody but the spammer."

The lure of the stock spam scheme is as old as stock speculation itself: Buy low and sell high. The difference is that, in many cases, it was the spammer who buys shares of penny stocks and then promotes the stock in e-mails. If even a few dozen investors pick up on those stocks, the momentary uptick creates a windfall for the spammer, who in many cases sells to the unwitting online buyer.

"If a spammer can take a penny stock and turn it into a nickel stock, even for a few hours, he walks away with a significant profit," Frieder said.

Her study, a team effort involving her graduate students at the Krannert School and Jonathan Zittrain, professor of Internet governance and regulation at Oxford University, showed that online investors who fall for stock-touting schemes can lose as much as 8 percent of their investment over a two-day period.

"By the time an investor realizes that the increase in stock price is the result of a phony and orchestrated campaign, it is too late to get out without taking a loss," she said.

Frieder and Zittrain note that 730 million spam e-mails are sent weekly to computers around the world. Of that number, roughly 15 percent, or 100 million, push investors to get in on the next hot-selling stock.

Their draft study, "Spam Works: Evidence from Stock Touts and Corresponding Market Activity," was posted in July at the Social Science Research Network Web site. Along with the draft paper is access to the original data used in the study. Frieder and Zittrain have set up a simulator for would-be investors — those who send stock touts and those who receive them — to try their hand at making a profit before and during a spammed stock tout.

"We find that stocks experience a significantly positive return on days when they are heavily touted via spam, and on the day preceding such touting," Frieder said. "Volume of trading also responds positively and significantly to heavy touting.

"On a day when no tout has been detected in our database, the likelihood of a touted stock being the most actively traded stock that day is only 6 percent. On the other hand, on days when there is touting activity, the probability of a touted stock being the single most actively traded stock in our sample is 81 percent."

Just as the profits for unscrupulous spamming speculators can be significant, Frieder and Zittrain discovered that the losses suffered by investors are real.

"The day-trading practice among many independent investors seeking to buy low and sell high as the price moves up contributes to a fertile market for this kind of scheme," she said.

Beyond the buy-high-and-sell-low trap that day-trading investors fall into, Frieder said many also will pay a trading fee on the stock purchase and sale as the share price rises and falls.

Another discovery of the research team was that the actual owners of companies do not benefit from the momentary blip in stock price. They do, however, suffer a negative backlash when investors blame them.

"Many companies are completely unaware that spammers are buying up their shares, spamming thousands of potential investors and then dumping the shares before the price plummets," Frieder said. "They only find out about the scheme when duped investors call or e-mail them to complain that they were taken in.

"The whole process is completely beyond the control of individual investors or the penny-stock companies that spammers target."

The Purdue-Oxford study proposes more stringent regulation of unsolicited stock touting and spamming that would require those sending e-mails to disclose their holdings in any stock they promote. They also propose a variety of ways to prevent investors from executing too rapidly on impulsive decisions.

"Disclosure of the odds isn't enough in a Las Vegas casino. The slots still have to pay out a certain minimum," Zittrain said. "Similarly, those who are taken in by these scams ought to experience a reality check before losing their money, even if one argues they knew the risks."

Writer: Jay Cooperider, (765) 494-2077, jcoop@purdue.edu

Source: Laura Frieder, (765) 494-4462, lilfrieds@purdue.edu

Jonathan Zittrain, Oxford Internet Institute (617) 747-4277, enquiries@oii.ox.ac.uk

Purdue News Service: (765) 494-2096; purduenews@purdue.edu

We assess the impact of stock touting via unsolicited e-mail upon the stocks' trading activity and sketch how profitable spamming might be for those who manipulate stocks via spam, as well as how harmful it is to those who might heed advice in stock-touting e-mails. We suggest that the profitability of spammed stock touting calls for adjustments to securities regulation models that rely principally on the proper labeling of information and disclosure of conflicts of interest in order to protect consumers. Based on a large sample of touted stocks listed on the Pink Sheets quotation system, we find that stocks experience a significantly positive return on days when they are heavily touted via spam and on the day preceding such touting. Volume of trading also responds positively and significantly to heavy touting. Indeed, on a day when no tout has been detected in our database, the likelihood of a touted stock being the most actively traded stock that day is only 6 percent. On the other hand, on days when there is touting activity, the probability of a touted stock being the single most actively traded stock is 81 percent. Returns in the days following touting are significantly negative. The evidence accords with a hypothesis that spammers buy low and spam high, purchasing penny stocks with comparatively low liquidity, then touting them — perhaps immediately after an independently occurring upward tick in price, or after having caused the uptick themselves by engaging in preparatory purchasing — in order to increase or maintain trading activity and price enough to unload their positions at a profit. Selling by the spammer then results in negative returns following touting. Investors who respond to touting are losing, on average, 5.25 percent in the two day period following touting. For the quintile of stocks in our sample that are touted most heavily, this two-day loss approaches 8 percent. These estimates are conservative, as they do not account for transaction costs.

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