Big Losers Can Turn Into Short-Term Winners
by Charles Rotblut | November 14, 2019
Would you buy a stock whose price performance ranks among the worst 10% of all exchange-listed stocks? What if the stock was also small, had proportionately low amounts of trading activity and was more subject to stock-specific volatility? Would you be interested?
If you said “no,” then you’re not alone. Many investors would initially view such stocks as being unappealing. They may be too pessimistic about the very short-term outlook for these loser stocks. A new study finds these types of stocks realize strong one-month outperformance as a group.
The study’s authors looked at the relative performance of stocks with a high and low loss probability (LP). Loss probability was quantified as the fraction of total trading days in a month when a stock’s return was below the risk-free rate (the return of an investment expected not to lose value on an absolute basis). The average monthly risk-free rate over the period analyzed (1963 through 2016) was 0.001%. Stocks were then grouped by deciles from best to worst. The excess return over the month following the creation of the high LP stock portfolio was 1.243% versus 0.360% for the low LP stock portfolio.
While we don’t advocate one-month trading strategies—especially those involving a large number of securities, which is what the study’s findings are based on—there are various insights within the study worth pointing out.
One is the concept of reversals. Though buying outperforming stocks (momentum) has been shown to work, it is based on realized performance over trailing periods of 13 to 52 weeks. When based on a shorter trailing four-week period, it doesn’t work as well. This fits in with the concept of stocks with high loss probability outperforming over the one-month period following portfolio formation. Though the loser stock study’s authors say their findings are not caused by reversals, they do acknowledge that the advantage of buying high LP stocks fades when the look-back period is extended beyond a month. This finding matches data supporting the concept of stock prices reverting to average on a four-week basis and stocks with comparatively longer periods of outperformance continuing to outperform.
Another is the idea of looking for investment candidates where others aren’t or can’t. The high LP effect was stronger among smaller and less liquid stocks. These stocks also tended to have higher levels of individual volatility as opposed to reflecting more market volatility in their price movements (aka high idiosyncratic volatility). Notably, the high LP effect was also noticeable in stocks with high analyst coverage. The latter might be due to limits on arbitrage and/or an unwillingness of investors to buy stocks they perceive as too risky.
Finally, there is the concept of applying research to a real-life portfolio. The study discussed here did not consider transaction costs, which could have a significant drag. For individual investors, implementing the strategy would require the purchase and constant reconfiguration of an approximate 400-stock portfolio based on the current number of exchange-traded stocks—a daunting task.
When studies like this are published, it’s often better to incorporate parts of the findings than to try and replicate the entire strategy. In this case, the big takeaways are to look where others aren’t and to not ignore the losers as there may be opportunities among them to pick up certain stocks at bargain prices.
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Finding Bargains Among Stocks With Falling Stock Prices – This contrarian strategy seeks out stocks whose price drops may have turned them into bargains.
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Why Contrarian Investors Should Treat Falling Knives With Skepticism – Not all underperforming stocks are bargains. Here are some warning signs to look out for.
Slightly more than two out of five investors are optimistic about the short-term direction of stock prices for the second consecutive week. The latest AAII Sentiment Survey also shows a modest increase in pessimism and a decline in neutral sentiment.
Bullish sentiment, expectations that stock prices will rise over the next six months, is 0.4 percentage points higher at 40.7%. Optimism was last higher on May 8, 2019 (43.1%). Bullish sentiment is above its historical average of 38.0% for just the 10th time this year.
Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, declined 1.3 percentage points to 34.5%. Even with the decline, neutral sentiment is above its historical average of 31.5% for the 25th time in 26 weeks.
Bearish sentiment, expectations that stock prices will fall over the next six months, rose 0.9 percentage points to 24.8%. Pessimism is below its historical average of 30.5% for a fourth consecutive week.
As stated above, bullish sentiment is above 40% for the second consecutive week. This has not happened since August 29 and September 5, 2018 (43.5% and 42.2%, respectively). Since then optimism has only been above its historical average on consecutive weeks two other times: February 20 and 27, 2019, (39.3% and 41.6%, respectively); and May 1 and 8, 2019 (39.0% and 43.1%, respectively).
At current levels, all three indicators are within their typical ranges.
The improvement in optimism occurred as the major indexes set new record highs. Many individual investors continue to monitor trade negotiations, particularly between the U.S. and China. Also having an influence on sentiment are Washington politics, geopolitics, valuations, corporate earnings, economic growth, monetary policy and interest rates.
This week’s special question asked AAII members what their thoughts were regarding the S&P 500 index reaching a new record high. Opinions on the new highs are overwhelmingly split, with approximately 43% of respondents viewing the new highs as unsustainable and due for a correction. Some respondents in this group believe that the record-breaking highs are a sign of the tail end of the bull run. On the other hand, 38% of respondents say that the S&P 500 highs are appropriate given current interest rates and limited investment opportunities outside of equities. A majority of this group also state that they believe the S&P 500 will continue to rise well into 2020. Additionally, 11% of respondents say the new highs are in response to developing trade resolution talks and 8% state that they have no opinion on the matter.
Here is a sampling of the responses:
- “The economy is strong, and stockholders are optimistic. The yield on bonds is low limiting investment options.”
- “False sense of security despite highly volatile geopolitical/economic conditions.”
- “I have no thoughts. This is just another number. As long as corporations continue to spend the money to buy back their stocks, earnings will continue to be supported by fewer shares traded.”
- “No other place to put money to get a decent return, so equities are the best. Even though the markets are high, one wonders how long equities can go without overpricing.”
- “The S&P 500 has achieved record highs over the last week. History suggests that that might reverse soon.”
Bullish: 40.7%, up 0.4 points
Neutral: 34.5%, down 1.3 points
Bearish: 24.8%, up 0.9 points
Bullish: 38.5%
Neutral: 31.0%
Bearish: 30.5%
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