Excess Returns Out of the 52-Week High

Published by Filipe R. Costa on Tue, 08/07/2014 - 15:28
52week high

Investors are always seeking for ways of getting some advantage relative to the market that can provide them with the ability to get some alpha profits. Some dig very deep inside company financial statements, others look into all kinds of technical indicators in an attempt to identify some pattern, others break the insider trading rules, and even others trade on their emotions and impulses. One way or another they are deemed to fail if the efficient market hypothesis is valid, as many argue it to be.

From long ago, the most recent Nobel Prize winner, Eugene Fama, argues that you better give up on trying to beat the market, as it is unbeatable by nature. If a profit opportunity arises, out of some identifiable chartable pattern, then all investors would jump into the same strategy in no time and the profit opportunity would cease to exist. So, looking at past data, either prices or news, doesn’t give you an advantage and the best you can do is to achieve the same profits as the market as a whole. Even if you look into the future prospects of a company, you won’t be any better. The competition between fund managers assures that all information, being it past or prospective, is already priced into shares.

While the above seems reasonable, we now know it isn’t right. Markets are not that efficient and the price you observe for a share is its rational price… until it isn’t… and we know that under certain conditions there are really sudden and wide changes. Just look at past bubbles. How can we justify that house prices were rational until 2007? Was there such a sudden change in the market to justify the big drop we observed in house prices between 2007 and 2009? Certainly not, so the inflated prices until 2007 were partly irrational.

So, if prices have some irrationality, then there is some good news deriving for us. It means that we can predict them. It means that technical analysis, in fact, can derive value, and that fundamental analysis can also help. Looking at past prices is sometimes enough to make a profit as shown by many academics. We can point to Jegadeesh and Titman, who in 1993 have shown that buying the shares of companies that have performed well during the recent past do result in future good performance at first and then bad performance as time goes on. So momentum and contrarian strategies do work.

Seeking for excess returns has always been the main goal of investors and at the centre of academic research on behavioural finance. Some important work has identified a myriad of anomalies in the stock market: the January effect, the Holiday effect, the Weekend effect, the Halloween effect, and many others. Profit opportunities repeat over time. Every year, every period, the same opportunities are still available. Why?

Well, who said investors are rational and take unbiased decisions? Someone in fact said that and millions believed it was reasonable to accept it. But it isn’t. Do you really believe that before taking an investment decision, an investor always looks into every piece of information available about a company? Do you really believe that the human being is unbiased? So, many investment decisions are taken without all information being evaluated. Investors look at anchors and guide their investments based on them. Instead of looking at a company’s prospects, it is easier for example to look at its price and evaluate it against the company’s 52-week high or low.

In a paper published in 2012, Li and Yu, two researchers from the University of Minnesota, claimed that you don’t need past prices to make excess profits. All you need is the current price, the 52-week high and the historical high. That’s enough to beat the market. Their intuition is as follows. Investors look at the nearness of the current price of a share to its 52-week high to gather the potential for share appreciation. When the price is near to the 52-week high, investors are reluctant to react to positive news and big higher prices, so they in fact underreact to news. This means that these stocks that are near their 52-week highs are undervalued. But as the information continues to flow in the same direction (positive news) the price then finally adjusts higher. So, the nearness to this 52-week high is a predictor of future positive returns. At the same time, they argue that the opposite effect occurs regarding the historical high. When the price is near the historical high, the company has most likely experienced a series of good news and traders tend to overreact to such. This means that when the price is near the historical high, the shares may be overvalued. So, the nearness to historical high predicts lower than average future returns, as opposed to the nearness to the 52-week high, which predict lower future returns.

So, adding all pieces together, we can get a list of share data with current price, 52-week high, and historical high. From these data we can compute the nearness to 52-week high as (current price)/(52-week high) and the nearness to the historical high as (current price)/(historical high). Then we can rank shares by their nearness to 52-week high (highest to lowest). The top of the list shows us candidates for undervalued companies. But, we still should control for nearness to historical high, as the companies with highest values are more likely to be overvalued.

We took a list of FTSE350 shares, as an example, and proceed as stated above. After ranking for the nearness to 52-week high, we selected the companies with a ratio at or above 0.95. Then we rank this list for the nearness to historical high (highest to lowest). The top of this new list shows us candidates for short selling while the bottom shows us candidates for long positions. Now we can select the top five of the list for candidates for short-selling and the bottom five as candidates for long positions, as shown in the table below.

So looking at current prices, you could select First Group, Hays, Intu Properties, Segro and BTG to build a portfolio. If you want a self-financed portfolio, then you could sell the other five in the short-selling part.

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Research & Opinion