Many value investors, myself included, tend to shy away from buying stocks which have risen significantly from their lows, or are trading at 52-week highs.
It takes time to get over the psychological barrier that prevents many investors from buying a stock when it is printing new highs. However, there is evidence that suggests investors should not be so cautious.
Winners and losers identified by the 52-week high strategy
During October 2004, a study was published in the Journal of Finance entitled, “The 52-Week High and Momentum Investing” the study, finds that ‘returns associated with winners and losers identified by the 52-week high strategy are about twice as large as those associated with the other strategies.‘ What’s more, the study brings into question the efficient markets theory, and questions the semi-strong form of market efficiency as 52-week highs are widely available figures, published in almost every newspaper. There is also evidence to suggest that ‘returns associated with winners and losers identified by the 52-week high strategy are about twice as large as those associated with the other strategies.’
The reasoning behind this conclusion has more to do with human error than skill. According to the paper, traders are slow to change and adjust their beliefs about a security’s value, and when they do adjust, they overadjust. Further, it was found that when traders react to news rumors, they push a stock’s price higher, overreacting, but when news is confirmed they push the stock price even higher, although this may be corrected over the long term (buy the rumor, sell the news). Overall, the way in which beliefs are updated causes price momentum and reversals. The paper goes on to state:
‘…Our results indicate that the 52-week measure has predictive power whether or not individual stocks have had extreme past returns. This suggests that price level is important, and is consistent with an anchor-and-adjust bias. Traders appear to use the 52-week high as a reference point against which they evaluate the potential impact of news. When good news has pushed a stock’s price near or to a new 52-week high, traders are reluctant to bid the price of the stock higher even if the information warrants it. The information eventually prevails…’
52-week high: Adjustment and anchoring bias
One of the explanations given for these results is the “adjustment and anchoring bias“, consistent with other studies done within the field of economics. This theory is based around experiments where by subjects were asked to estimate a quantity (number of trades made over 24 hrs) as an increment to a number generated randomly. The results of this study concluded that the higher the randomly generated number, the higher the increment quantity. Using these results, the article concludes that ‘traders might use the 52-week high as an “anchor,” like the random number in the experiments when assessing the increment in stock value implied by new information’.
While this paper does conclude that traders and investors should not fear the 52-week high, this information is more applicable to traders, who can get out quickly when the price reverses rather than long term investors.
This is by no means a thorough analysis of the paper, or indeed the successes of momentum. Nevertheless the above information does reveal some interesting trends and indicates that there is no reason to fear the 52-week high.
The full paper can be found here.