Citi, AIG, Fannie and Freddie: The Not Fab 4

NEW YORK (CNNMoney.com) -- Investors had a funny way of commemorating the first anniversary of the market's bottom on Tuesday. They rewarded some of the stocks responsible for most of the problems in the first place.

Shares of Citigroup (C, Fortune 500), AIG (AIG, Fortune 500), Fannie Mae (FNM, Fortune 500) and Freddie Mac (FRE, Fortune 500), which all to varying degrees remain dependent on the federal government for support, surged Tuesday. AIG led the way with a more than 13% pop.

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Shares of four big financials still receiving government support have been on fire for the past few days.

These four financial wards of the state were all rallying sharply again Wednesday morning, even though the broader market was only up slightly.

If Lehman Brothers, Bear Stearns and Washington Mutual were still around, I'm sure their stocks would have soared on Tuesday and Wednesday as well.

What gives? Well, the notion that the economy is slowly but surely getting better does bolster the case for financial stocks. But Tuesday's euphoria was not felt throughout the entire banking sector.

Shares of healthier banks such as JPMorgan Chase (JPM, Fortune 500), Goldman Sachs (GS, Fortune 500) and US Bancorp (USB, Fortune 500) fell Tuesday, while Wells Fargo (WFC, Fortune 500) was flat.

These four were all up about 1% in early afternoon trading Wednesday -- but that lagged the gains of AIG, Citi, Fannie and Freddie.

So it looks like the rally in companies with more questionable fundamentals and balance sheets that began last year is still alive and well.

"When a bull market begins, junk often outperforms the quality companies because they get a special premium simply for survival. But their problems aren't over. There are assets on the books that are still overvalued," said James Meyer, chief investment officer at Tower Bridge Advisors, a money manager in Conshohocken, Pa.

It seems more likely that investors, or shall I say traders, are making bets on rumors that so far have no basis in fact. There was scuttlebutt Tuesday, for example, that the SEC was going to ban or limit short selling in companies in which the government has a stake.

But the SEC flatly denied this talk. "There is no truth to the rumor that we are considering restricting the short selling of stocks in which the government has a stake," said SEC spokesman John Nester in a statement.

Sure, there has been some good news lately to explain why Citi, AIG, Fannie and Freddie (Let's call them the Not Fab Four. Or perhaps The Unfantastic Four?) have been moving higher.

Some value investors, including well-regarded Fairholme fund manager Bruce Berkowitz, have talked about why they like Citi. Analysts at influential fixed-income research firm CreditSights wrote in a report this week that Citi's "back in business."

AIG has sold two plum assets -- its Asian AIA life insurer to Britain's Prudential and its Alico life insurer to MetLife -- for a combined $51 billion.

Finally, the Treasury Department reiterated last week for the umpteenth time that it will support mortgage financing giants Fannie and Freddie, something that most believe is still needed to prevent another big upheaval in the housing market.

But none of this can explain why these four stocks have done so well in such a short period of time.

John Kolovos, co-head of technical analysis research with Concept Capital, an institutional brokerage in New York, said that there may be what's known as a short squeeze taking place with the stocks.

Short sellers get squeezed when stocks they've borrowed and sold short start to rise. Since short sellers can lose big if a stock they've shorted suddenly heads higher, they may have to rush to buy back the stock to cover their position.

What that means is that this week's surge may be more of a temporary blip than a smart-money bet the worst is over for these four companies.

"Short-term momentum is positive, but I don't see the moves as anything more than a pop. They're just moving on emotion mostly," Kolovos said.

Looking at the four individually, the company that's easiest to be slightly more bullish on is Citi.

For one, the bank has taken lots of legitimate steps to restructure and focus on its core banking business. Citi also launched an offering of $2 billion in trust-preferred securities Wednesday.

What's more, the government has a much smaller stake in Citi than AIG, Fannie and Freddie. And the backing of Fariholme's Berkowitz should not be dismissed.

AIG? Sure, it's great that it's finally selling assets so it can begin paying back taxpayers. But it's fair to wonder whether there's anything left of value at AIG that the company can either sell at a decent price or rely on to help restore the insurer to sustained long-term profitability.

Fannie and Freddie? Talk about damning with faint praise.

The only thing to get excited about is that Treasury once again said it's not pulling the plug on them. And the main reason it felt inclined to repeat this was because House Financial Services chairman Barney Frank spooked the markets Friday by suggesting that Fannie and Freddie bonds shouldn't necessarily be considered as safe as Treasury debt.

So anyone wading into AIG, Fannie and Freddie needs to be careful.

"You have to label AIG, Fannie and Freddie as speculation. If you want to speculate, understand you're speculating, not investing," said Meyer. "There's nothing wrong with that bit you have to do at the right time and when the wind's at your back."

Kolovos agreed and urged caution on Citi as well. He said that investors should be wary of the big moves, particularly for Citigroup, Fannie and Freddie.

That's because those three stocks still trade for under $5, which makes them far more subject to big percentage gyrations and heavy volume. Kolovos referred to the stocks as "single-digit midgets."

"These companies have tons of shares, so the spike on the surface seems encouraging, but you have to be careful. Citi's a $4 stock that's still spinning its wheels," he said.

-- The opinions expressed in this commentary are solely those of Paul R. La Monica.