By Louis B Llanes, CFA CMT
Founder, Wealthnet Investments, LLC 

The Truth About New Highs in Stocks and the Market in Recent History

What does it mean for investors when stocks are at new highs? Does it really matter? On this Market Call, I compare the performance of stocks reaching new highs versus those starting to go up after a 50% or more decline. I compare them in bull and bear markets to see the performance in different market environments. The results may surprise you. I know it has surprised some of my colleagues that are long-term pros in the investment business.

There is a lot of confusion when it comes to Wall Street wisdom. We always strive to test out theories to see if they have some validity rather than just accepting the common wisdom.

I will explain what it means to buy stocks that are at new highs. This is currently crucial because we're at near new highs right now in the stock market and many people are concerned that the market is overbought and that it’s going to turn negative soon.

There are two competing thoughts and frameworks on Wall Street. One of them is to follow the trend. This theory says “the trend is your friend until it bends at the end.” A lot of people follow this strategy which is often called a momentum strategy.

The other common strategy is to buy stock that are beaten down. Many pros in the business who are value investors subscribe to this theory. They like to buy “fallen angels” that have gone down 50% or more so they can pick up a bargain.

Testing New Highs Versus Beaten Down Stocks in the S&P 500

We tested stocks in the S&P 500 from March 24, 2000 to March 8, 2013. I picked this period because this timeframe includes two bull and bear markets and they are very extreme. This gives us the ability to see new highs and beaten down stocks perform in different markets. We are going to shed some light on what happens with new highs and buying stocks that are beaten down during both bull and bear markets.

Volatile Bull and Bear Markets

This chart shows the bull and bear markets and you can see that they were extremely volatile. We hit a high in March 2000 and then it came down really strong in October 2002,
which was a big move. It had a big rally and then it came back down. In general, if you look at that whole period from that high that hit in March of 2000, we never really made any further progress.

Removal of Survivorship Bias

When testing the signals for this chart, we wanted to ensure our data wasn’t biased, so we took out all the survivorship bias problems and only looked at the historical constituents of the market. This is important is because you can have stocks that went out of business, companies that did poorly or went through mergers and acquisitions, and we wanted to test that with what really was able to be traded during that timeframe.

Equal Weight S&P 500 Benchmark to Measure Performance

We also compared the performance of our signals to an equal weighted S&P 500 benchmark to determine when the signal was adding value versus buying a stock at random. The reason we did that is because an equal weighted index means you put the same amount of money in each stock that you own, which inherently has an upward bias relative to the S&P 500. In other words, the equal weighted index tends to outperform the market. We were conservative and made our benchmark the harder-to-beat equal weighted benchmark.

This chart shows on the top, the usual one that you see in the news which is market cap weighted, and the one on the bottom shows the equal weight. You can see over the test period between those two vertical lines that it had an upward bias during that period of time. So what we’re benchmarking to is something that outperformed the market.

Bear Market Signal Test

These are the bear market signals that we tested hitting new highs. The top section shows that this one was from March 2000 through October 2002. The second bear market was from October 2007 to March 2009.

We did a test in which we took the stocks that were getting within five percent of their high and then we bought them and held them for a year and analyzed what happened over that time period. We also included statistics that show the mean or average return, the median return, and the percentage or probability of gain over the year. Following that, we looked at the distribution to 80th percentile, or the stocks that really went up a lot versus the 20^th percentile, which were at the lower end of the range. This gives us data to analyze the risk of the distribution of returns.

Stocks Near Highs Statically Had Better Outcomes in Bear Markets

This chart compares that crossed within 5% of the 252-trading day high. 252 trading days is approximately one year. These stocks that were five percent from high were analyzed to see how they performed for the next year. We did the same thing with stocks that were 50% below their 252-trading day high and bought them crossing above that 50% retracement line.

The column on the right shows an interpretation comparing the two. When it says “better”, it means that the five percent stocks are doing better than the 50 percent stocks.

The statistics show that stocks near highs have performed better than those fallen angels that started to move up from a 50% retracement.   We see this in both bear markets under study. So

This suggests that during bear markets, buying stocks that are closer to the highs is smart and statistically will have better outcomes.

Stocks Down 50% Starting to Rise Have Higher Risk

This chart above details the return distributions of the different signals. We want to find distributions that have positive returns and tighter ranges that are less spread out.

The two graphs on the left are the five percent from high signals and the two on the right are the 50 percent from high signals. Looking at these, you can easily see that the five percent from high has a much more concentrated distribution and it's not as sporadic. The 50 percent from high has a very wide distribution, suggesting that there's a lot of risk in buying those “fallen angel” stocks, which contain a tremendous amount of risk.

Bull Market Signal Test

This chart is consistent with the previous Bear Market Signal Test, but this time we are looking at Bull Markets.

In the first bull market, you'll notice that buying five percent highs was worse than buying the stocks that were down 50 percent which makes a lot of sense, because when the economy is doing better, a lot of companies that were selling off or not doing well were starting to come back to life. With that said, there's still a lot of risk with the fallen angels.

What we see in the second bull market is the main return in the five percent from high signals was better than the 50 percent from high. All other statistics show the 50 percent form high performing better, so it's not as conclusive in that time period that buying highs outperforms.

This is something that we’ve seen consistently with the data - buying new highs doesn't necessarily mean that those stocks are going to outperform during a bull market.

Beat Down Stocks Do Better in Bull Markets!

Looking at this distribution charts, you see the same phenomenon from the bear markets. There is still a really wide distribution, suggesting that it's not reliable to buy stocks that are 50 percent off their high. It's dangerous even in bull markets. It’s important to notice on the left side, the stocks five percent from the high a year after you buy them. They tend to have a tighter pattern of returns and they may not necessarily outperform the market, but you don't have as many sporadic, large downdrafts.

Stocks tend to Mean Revert in the Short Term After New Highs

This chart shows what happens during both bull and bear markets when you buy new highs. We’re looking at both bull and bear markets to see the general tendency of returns on a daily basis going forward for the next year.

The red line shows how much the basket of stocks that are getting the signals are outperforming or underperforming the market. If it's above zero, that's outperforming, if it's below zero, it's underperforming.

The green line is the signal line that's showing you the results from the signal and shows the confidence bands around it. You can see that right after you hit new highs, there's a tendency for mean reversion where the generally underperforms in the short term. In the long term, up to about 130-140 trading days, they outperform. After that, the tendency is the lag.

This is important to understand because a lot of times when you're trading these highs, you have an opportunity to buy them on pullbacks and that is a valid strategy based on this chart and statistics that we've seen in this timeframe.

The other thing to point out is that it does keep up with the market fairly well within the confidence bands all the way out to almost a year. However, it does tend to have a decay factor - the longer these new highs have been going on, the higher chances are that you can start underperforming.

This is one of the reasons why when we do technical analysis, we always explain that you don't want to buy multiple highs after this.

Recapping Long Positions

This recaps the long positions across the board. It might look a little confusing, but basically it illustrates that the distributions on the bottom two are very wide.

When you try to buy these 50 percent droppers, you are dealing with a lot of risks.

If you're buying new highs, you have a tighter return pattern, but that doesn't necessarily mean you're going to outperform the market.

In summary, statistics show that buying highs beats buying lows in bear markets.

Another thing to remember is buying lows is dangerous and can lead to significant losses, especially in a financial crisis or regular bear markets.

Buying lows is a high-risk/high return strategy. It requires more bottom up analysis, truly understanding your companies, and smaller position sizes. You don't want to have a position size that increases your risk, and you want to have much more diversification when you're doing that.

Buying highs has a tighter distribution with less large losses, but it doesn't always beat the market. There has been a tendency for mean reversion in the short term after highs, but outperformance in the intermediate term.

When you buy highs on a rolling basis, you tend to beat the market to about 140 trading days.

Bottom Line: You can make money in both a “fallen angel” and a “trend is your friend” strategy. Neither is superior at all times, but what is very certain is that it's a higher risk strategy to try to buy those beaten down stocks.