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Buy High and Sell Higher by Greg Forsythe, CFA, Senior Vice President, Schwab Equity Ratings®, Schwab Center for Financial Research December 20, 2005 Reprinted from the November 2005 issue of Schwab Investing Insights™, a bimonthly publication for clients of Schwab Advised Investing Signature™ and Schwab Private Client™. Every day, newspapers and websites publish lists of stocks whose prices have just established new 52-week highs and lows. Many investors, perhaps recalling the old adage "buy low and sell high," view the 52-week-high list as a collection of stocks to avoid. But as is so often the case in investing, doing what's uncomfortable may be the path to market beating returns. Academic researchers learned long ago that stock prices appear to have "momentum." For example, stocks with the best price performance over the previous six-to-12-month period tend as a group to continue to outperform the market over the subsequent one-to-12-month period, while previous losers tend to continue underperforming. Stock price momentum is one of the 18 factors used in Schwab Equity Ratings' analysis. Recent academic research has uncovered a new stock price-driven factor that's related to momentum but distinctly different. An article in the October 2004 Journal of Finance1 showed that the closer a stock's current price is to its 52-week high, the stronger that stock's performance in the subsequent year. In colloquial terms, this research seems to suggest a strategy of "buy high and sell higher"! Playing catch-up Why would such a seemingly crazy strategy work? First of all, stocks that have outperformed the market over the past year and are currently near their 52-week highs tend to share one important common characteristic. These firms have tended to report financial results that exceeded prior consensus expectations. Investors react to these positive surprises by bidding up these firms' stock prices. Of course, if the stock market were perfectly efficient, this rearview mirror look at past stock price performance would have no value in predicting future performance. But interestingly, it seems that while investor reaction to positive news is in the right direction, it's not as strong as it should be. In other words, investors tend to under-react to positive surprises. This effect explains why past price momentum can be used to forecast future excess returns as investor expectations play catch-up with stocks' current fundamentals. Stocks near their 52-week highs not only tend to have positive momentum, but they have another psychological driver working in their favor. Investors tend to react even more slowly to positive news reported by companies whose stock prices are near 52-week highs. In other words, investors are so worried about "buying high" that their reaction to company news is not perfectly rational, but instead is partially influenced by a stock's proximity to its 52-week high. Consequently, contrary to most investors' expectations, stocks near their 52-week highs tend to be systematically undervalued. How can you benefit? The great news from a practical standpoint is that even long-term investors can benefit from this phenomenon. That's because, while outperformance of stocks currently near their highs is typically strongest over the next one to six months, outperformance tends to continue even beyond the next 12 months. I wouldn't recommend investors base an entire strategy on price momentum and/or 52-week-high proximity. Schwab Equity Ratings provides a much more comprehensive and powerful method for assessing a stock's prospects. But stock price-based indicators can be used as secondary criteria. For example, one could first screen for A-rated stocks and then cross-check that against their 52-week highs to narrow down the A-rated stock list to a manageable number for further research. The hope is that these stocks would not only benefit from the 52-week-high effect, but by virtue of their attractive Schwab Equity Ratings might also have the fundamentals, valuation and risk characteristics to support further outperformance over the next year. 1. "The 52-Week High and Momentum Investing," Thomas J. George and Chuan-Yang Hwang, The Journal of Finance, October 2004. Description of Schwab Equity Ratings and Components
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The type of securities mentioned may not be suitable for everyone. Each investor needs to review a security transaction for his or her own particular situation. Data contained here is obtained from what are considered reliable sources; however, its accuracy, completeness or reliability cannot be guaranteed. (1205-9983) Return to Top |
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