Wednesday, October 18, 2006

When Lots of Stocks Are High, Should You Buy?

Each day in the Trading Psychology Weblog, I track the number of stocks making new 20-day highs and 20-day lows. These give us an intermediate-term sense of whether the market is strengthening or weakening. How about the bigger picture, however? If many stocks are making 52-week highs, does it pay to buy?

I went back to 1990 (4196 trading days) and computed the number of 52-week NYSE highs as a percentage of the total issues traded each day. What we find is that there were 136 occasions in which 10% or more of traded stocks made fresh 52-week highs. One such occasion occurred this past Monday.

What we find is that, 40 days after we get a large number of new highs, the S&P 500 Index ($SPX) is up on average by only .32% (68 up, 68 down). That is a subnormal return when compared to the average 40-day return of 1.47% (2695 up, 1501 down) over that period.

In other words, buying stocks when lots of stocks are high has not been a good buy.

How about the reverse?

When only .5% or fewer of stocks are making new highs (N = 202), the next 40 days in $SPX average a sizable gain of 4.34% (164 up, 38 down), much better than average.

When very few stocks are making new highs, it's been worth a buy.

It is only human nature to become more bullish as more stocks are making fresh highs. But if human nature were rewarded in the marketplace, we'd see more trading millionaires.


yinTrader said...

Hi Brett

When very few stocks are making new highs, it's been worth a buy.

It is only human nature to become more bullish as more stocks are making fresh highs. But if human nature were rewarded in the marketplace, we'd see more trading millionaires. -Unquote

Sounds like Buffet philosophy!

Chad Patel said...

Why 40 days later? Did testing of 1, 5 or 20 reveal no significant bias? I wonder if those might be relevent too?

Brett Steenbarger, Ph.D. said...

Hi Yin,

I would rather have his investment results than his philosophy, but maybe the two go hand in hand... :-)


Brett Steenbarger, Ph.D. said...

Hi Chad,

Thanks for the question. I was focused on the big picture, but in fact the returns were subnormal over every time period up to 40 days when we had more than 10% of stocks making new annual highs.


Howard Lindzon said...

great info and intuitive but nice to see some facts

Brett Steenbarger, Ph.D. said...

Thanks Howard,

I've been following what you've been up to through the Trader Mike updates. Really sounds like good stuff. Do keep me posted when you put out really juicy stuff and I'll be happy to link and let people know what you're up to--


Jack Doueck said...

Dear Brett, love this blog, hope this is not too off topic -- wanted your opinion...

I work at Stillwater Capital, and was thinking about hedge funds and some of these funds blowing up, and thought that I would add my two cents and see if you had anything to add too – but I just wanted to say a few things after reading your last thought here… recently many investors were hurt by Amaranth and other funds, and I was thinking about the ways some of those affected are going to sort through the damage, here are some principles they may want to have in mind:

1. Sophisticated hedge funds apparently have no clue about should have basic concepts like money management, position sizing and ‘risk of ruin‘ knowledge, and should use stops or have a point where they know to exit.

2. Bennett McDowell once said that, “Money management in trading involves specialized techniques combined with your own personal judgment. Failure to adhere to a sound money management program can leave you subject to a deadly “Risk-Of-Ruin” exposure and most probable equity bust.”

3. The smaller the amount you risk for any one trade relative to your capital base the lower the risk of ruin.”

4. And of course it goes without saying that a good hedge fund investor has to pick good funds to invest in. The key, though, to success in this business, is not to choose the best performing managers, but actually to evade the frauds and blowups.

5. With both frauds and blowups, contrary to public opinion (and myth), size does NOT matter: Beacon Hill was $2 Billion, Lipper was $5 Billon, Amaranth was $9 Billion).

Suffice it to say that these should be some of the main points investors should think about as they interview and select hedge funds to entrust their dollars to.

Do you agree with this?

Jack Doueck
Stillwater Asset Backed Strategies
Stillwater Capital

Brett Steenbarger, Ph.D. said...

Hi Jack,

You make excellent, excellent points; thanks for the note. My one modification of your comments is that many funds and money managers know risk management but are so pressured to show short-term outperformance that they take undue risks. That having been said, I believe that an understanding of risk of ruin is essential to all traders and investors. Small traders, like large institutions, sometimes trade too large for their accounts to juice returns, making blowup inevitable.