All-Time High Stocks: Why 52-week and All-Time Highs Outperform

William O'Neil said in his book How to Make Money in Stocks: "The hard-to-believe Great Paradox in the stock market is What seems too high in price and risky to the majority usually goes higher eventually, and what seems low and cheap usually goes lower." This observation confirms what other speculators like Nicolas Darvas and Braden Glett have written about.

But why does this happen? Is the market actually inefficient?

This is important, I think, and I agree with the perspective posed by Michael on his efficientish blog: "My feeling is that I need to be able to explain, in simple terms, the psychology behind the pattern for it to have any use to me. If I do not understand why a pattern works, how can I have any confidence that it will work the next time?"

This brings me to a paper written by Thomas George and Chuan-Yang Hwang in the Journal of Finance (available here). Its title is "The 52-Week High and Momentum Investing". Here are some of their findings (all emphasis is mine):

"When coupled with a stock’s current price, a readily available piece of information— the 52-week high price – explains a large portion of the profits from momentum investing. Nearness to the 52-week high dominates and improves upon the forecasting power of past returns (both individual and industry returns) for future returns.
"Future returns forecast using the 52-week high do not reverse in the long run.
"Our evidence suggests that a model in which agents’ valuations depend on nearness of the share price to an anchor will be successful in explaining price dynamics.
"momentum behavior occurs when prices achieve long-run highs and lows. The intuition is as follows. Suppose good news arrives that pushes prices above the price at which irrational agents acquired the shares. The price change will understate the full impact of the news on fundamental value because demand of the irrational agents is lower (selling pressure is greater) than it would be in a rational market. Stocks at or near long-run high prices are likely to have experienced good news and to be trading above acquisition prices. Hence, the current price will not fully reflect the impact of the news on fundamentals. The price will increase further when prices eventually converge to fundamental value, resulting in momentum.
"these findings present a serious challenge to the view that markets are semistrong-form efficient. The nearness of a stock’s price to its 52-week high is public information. The more interesting finding, however, is that nearness to the 52-week high is amuch better predictor of future returns than past returns to individual stocks.
"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 and the price moves up, resulting in a continuation.
"traders’ reluctance to revise their priors is price-level dependent. The greatest reluctance is at price levels nearest and farthest from the stock’s 52-week high. At prices that are neither near nor far from the 52-week high, priors adjust more quickly and there is no pronounced predictability when information arrives.

The potential for 52-week highs to outperform is caused by price anchoring - a cognitive bias rooted deep in the human brain that is not going away anytime soon.

All-time highs are a special case of 52-week highs and I see no reason why this bias should not apply even more to the all-time price anchor. Therefore, exploiting a cognitive bias of other market participants provides the opportunity to outperform.

Related Posts