What’s The Logic Behind “Don’t Short New Highs Or Buy New Lows”
By Nick Colas of DataTrek Research
Whenever we write “Don’t short/sell new highs or buy new lows” we get client questions about that statement. We now offer a fuller explanation of this maxim. Academic research on price momentum as a predictive return factor supports the idea of being careful around new highs and lows. There is also enough information asymmetry in markets to be cautious when going against the tide of peak/trough prices. Bottom line: asset price extremes merit careful, deliberate, and intellectually humble consideration.
DataTrek’s Nick Colas occasionally tells readers “Don’t short/sell new highs or buy new lows”. This observation often draws client questions or comments, and that’s understandable because it seems to repudiate the idea of “buy low, sell high”. Here, Colas takes a step back and explains it more fully.
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I will first cover why I think that’s good advice and then offer up two illustrative examples of when I’ve broken the rule and still made money. A word of explanation first. By “new” we mean both 52-week and all-time highs and lows, with the latter being an obviously more noteworthy version of the former.
Why this is good advice:
#1: New highs and lows are special because they are highly visible markers of price momentum. Academics have been looking at the momentum factor since 1993 and there is enough research to confirm it is a valuable signal. One recent analysis (August 2020, link below) found 100 percent replicability relative to prior research for the momentum factor being significant to future returns across geographies. The jury may be out on whether momentum stocks adequately compensate you for the risk they carry (link below), but that matters very little when you’re short a high beta name or underweight a group/asset class that’s consistently making new highs.
#2: Someone is buying that new high, so you have to ask yourself “what do I know that they don’t?” Take our call earlier this year on the Russell 2000 as a simple example. From its breakout to new all-time highs last November, it made 16 new highs through its ultimate top in March 2021. Only the last three or four were truly useful sales for an investor benchmarked and regularly judged against broad US equity indices.
In April, we showed you why US small caps were not likely to outperform going forward: their recent performance had been so statistically aberrant (5 standard deviations) that this asset class was due for a protracted period of underperformance. That has proven correct, and we’re still biding our time. What we “knew” was straightforward (excess small cap hype would lead to garden-variety mean-reversion) but we waited a few weeks before making that call because of our respect for Point #1 above. And … There was still plenty of time to underweight small caps in Q2 and outperform for the quarter. Our information edge in this case was statistical (a 5 sigma move), but certainly it was still grounded in the idea that we had to know something the market didn’t fully appreciate.
#3: While one might sell a new high for perfectly valid risk management reasons (position concentration, for example), buying new lows is more fraught with challenges. First, you have the problems highlighted in the prior 2 points: momentum and information asymmetry. The latter issue is more acute in new lows. Current shareholders are doing at least some of the selling at those levels and there’s a good probability they understand the story better than you do. Second, buying a new low often occurs alongside “doubling down” in an existing (and losing) long position. You know the old joke “how long can a stock lose 5 percent/day?” The answer is forever, so we always advise waiting for a stock to find a bottom for a week or two before adding to an already underwater position (even if it is not making 52-week lows, by the way).
Now, there are certainly times when buying new highs or lows can make sense. Here are two examples from my own career:
Buying new lows – Chrysler in 1991. At the trough of the global recession caused by the 1990 Iraqi invasion of Kuwait I worked on an equity issuance for Chrysler. The stock had gone from the high $40s in the late 1980s to $5 in November 1991. Selling stock at multi-year lows was hard. Investors had to believe in both a US economic recovery and Chrysler’s new product launches, many of which were still years away.
To give investors confidence in the company’s future, Chrysler did something that was – and still is – unprecedented in the auto industry. They hauled every new vehicle prototype and model to New York City, displayed them in the grand ballroom at the Waldorf-Astoria hotel, and had master pitchman/CEO Lee Iacocca give a standing-room only presentation to +500 institutional investors. Lee, like Frank Sinatra, only worked the big rooms because they gave the aura of stardom. It worked. The deal priced, the first of the new models (the Grand Cherokee) started production, US vehicle demand began to increase, every new product was a hit, and Chrysler went from $5 to $40 in a few years.
Shorting new highs: GM in 2000. General Motors spent much of the 1990s buying and building up a variety of non-auto businesses like Ross Perot’s EDS and Hughes Electronics. Both had their own tracking/letter stocks (GME, GMH), which allowed investors to value GM as a “sum of the parts”. The problem was that E and H grew much faster than the auto business, so investors wanted more of those businesses and less of core GM. In 2000, General Motors offered investors a swap of GM shares for GMH. In the run-up to the transaction GM’s stock got to $95, a level it had not seen for the entire decade.
I was significantly short GM into that swap, and for a sleepless day or two it did not drop. Then the news came out that deal was wildly oversubscribed – there were millions of shares owned by arbitrageurs who would not be getting as much GMH as they had hoped. My investment thesis had been rudimentary, at best: “once this deal is done, no one will really want to own plain-old GM”. I had not fully incorporated the role the arbs would be playing, but their participation made this trade one of the best of my career rather than just a decent idea.
The bottom line to these stories is that “Don’t buy new lows or short new highs” should really read “Be extremely careful when doing either”. Caution around highs and lows is essentially good investment process risk management. Going against the tide can pay off handsomely, to be sure. Just be careful, we suggest, when dealing with new highs and lows.
Review of factor investing: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3774514
Momentum vs. risk compensation: https://www.institutionalinvestor.com/article/b1ny4j75kcqzcp/Academics-Say-Momentum-Factor-Is-Much-Weaker-Than-You-Think
Mon, 07/19/2021 – 09:31