How to hunt down shares that are leading the market recovery

It might be a bit soon to say the market is properly recovering from last year’s sharp slide, but some stocks have rebounded strongly in 2019. And for others, the correction last year hardly dented their price momentum at all.

In these kinds of choppy conditions, one screening strategy that offers an interesting perspective on the market is the 52 Week Highs list. After a spell of downward pressure, it acts like gauge of shares that are bouncing back fastest.

Most investors take a passing interest in the stocks that are hitting new highs. It’s the kind of data that can be found in newspapers and on financial websites everywhere. But what makes the 52 week high such an interesting datapoint is the psychology behind it. A couple of decades of academic research has shown that ‘new highs’ can provoke all sorts of irrational behaviour in investors...

So whether you’re interested in price momentum and new highs or not, just knowing about this irrational behaviour might give you a more objective view about how the market reacts to 52 week highs - and how to profit from them.

What lies behind the 52-week high?

On its own, the 52 week high is a pretty static number. Yet research shows that stocks hitting new highs often drift higher in price over the following weeks and months.

This upward trend is called “post earnings announcement drift”. It’s an academic name for when investors only slowly buy shares that are already trading around new highs. When earnings news about these kinds of share is published, particularly if it’s a positive earnings surprises, prices can be slow to react (as market efficiency momentarily goes out the window).

This confused reaction is caused by what the psychologists Amos Tversky and Daniel Kahneman called anchoring-and-adjustment. The idea is that humans form an anchor, or a belief, using a reference point (like a share price). As new information comes to light (like new earnings news) they only adjust their beliefs slowly, before going on to buy the shares at even higher highs.

In investing, the idea of anchoring around events like 52 week highs and earnings surprises is thought to be a big contributor to the ‘momentum effect’.

In fact, work by academics Thomas George and Chuan-Yang Hwang found that the 52 week high causes irrational pricing behaviour because of anchoring. As that behavioural brake is gradually released, the price drifts higher as momentum takes over.

Follow up research by the same team found that companies trading close to new highs and go on to deliver positive earnings surprises are particularly likely to experience post earnings announcement drift.

52 week highs and market conditions

Of course, in bearish conditions, when investors suddenly become risk-off and share prices fall across the board, a 52 week high strategy will be vulnerable. As the chart below shows, the market slide last year killed momentum in the 52 week high stocks that were in the portfolio at the time. As a result, it saw a -6.5 percent loss over the past 12 months - although it’s up 8.0 percent on a two year basis.

But when markets start to recover, this screen is one of the first to show which stocks have withstood the decline and are recovering quickest.

Here are some of the companies currently trading around their 52 week highs at the moment. The classic 52 Week Highs screen is here, but this take on it offers more details on the profiles of the stocks on the list, including their StockRank Styles and RiskRatings. Of around 50 stocks trading close to new highs (excluding financials), this is the top 10:

There is a fair spread between industry sectors here, with a couple of cyclicals, a couple of defensives and the rest ‘sensitives’. But the RiskRatings - which are our measure of medium term price volatility - point strongly to more Conservative, lower-vol names leading the market.

We used a minimum market cap filter of £25 million to remove very speculative names, but these are mainly large and mid-cap stocks. There’s also a “quality’ theme in here, which shows up in six of the top 10 being high “quality + momentum” High Flyers.

These stocks have the feel of safer, more predictable plays of the kind that soak up investment flows in periods of heightened uncertainty. Certainly the valuations of some of these names, based on their Value Ranks, could be seen to be fairly expensive.

So generally, it’s worth remembering that while the 52 week high seems like quite a straightforward measure, it’s actually got some interesting psychology behind it. The market tends to be wary of bidding up the prices of stocks hitting new highs - but this can actually cause their prices to drift higher over time.

Right now, this quick exploration suggests that the highest new highs are tending to be found among larger, more conservative and higher quality firms. But that could easily change if the market becomes more risk-on later in the year.

Recognising the likelihood of anchoring in the market - especially as a potential driver of momentum - is useful. Just by knowing that events like 52 week highs can cause irrational pricing means it’s possible to choose to avoid them altogether or use the ‘new highs’ strategy to spot new trends.