Daily Gains Letter

Has the 52-Week High Momentum Strategy Been Debunked?

By for Daily Gains Letter |

Has the 52-Week High Momentum Strategy Been Debunked?

Even though the S&P 500 and the Dow Jones Industrial Average are both taking a breather coming off recent record highs, it’s fair to say they remain bullish. Investors who have been sitting on the sidelines might be wondering if the recent dip has created a good entry point, or if the slide will continue.

The fact of the matter is, it doesn’t matter if you’re a short-term or long-term investor, you need a well-defined entry point and exit point. For most, that means trying to time the market, which is virtually impossible.

The hunt to find the best strategy to predict price movements in the stock market is as old as investing itself—and the perfect equation continues to elude us. But that hasn’t stopped investors from inventing their own strategies, whether that means taking a more traditional approach with fundamental and technical analysis, or using more unconventional tactics, like checking your astrological sign.

What, apparently, has been the single best indicator for continued growth? For momentum investors, it’s all about finding stocks that are approaching their 52-week highs. The theory is not without some merit.

In their 2004 paper, “The 52-Week High and Momentum Investing,” Thomas J. George and Chuan-Yang Hwang observe that stock prices do not follow random paths and that returns are predictable. (Source: George, Thomas J. and Hwang, Chuan-Yang, “The 52 Week High and Momentum Investing,” The Journal of Finance October 2004; 59(5): 2145–2178.)

The best way to make gains on the stock market, they found, is to simply consider those equities trading near their 52-week highs, because they usually perform better than other stocks. That nearness to the 52-week high is a better predictor of future returns than the need to look at past results.

George and Hwang’s research was done using stock price data from 1963 to 2001 with equities held for six months. In the end, they found that investors who bought stocks close to their 52-week highs and sold those stocks at a price further away from their 52-week highs beat the market benchmark.

A lot has changed since 2001. You could argue that 2001 set the stage for a different kind of stock market behavior. In fact, data now suggest the 52-week high momentum play is no longer a profitable investment strategy.

Using this play in combination with other metrics can be profitable, though. A recent study showed that momentum profits tend to be higher when an investment portfolio is made up of companies with high revenues, low costs, and valuable growth options. Companies with these indicators outperform traditional momentum strategies by approximately five percent per year. (Source: Sagi, Jacob S. and Seasholes, Mark, S., “Firm-specific attributes and the cross-section of momentum,” Journal of Financial Economics May 2007; 84(2): 389–434.)

Investors that focus on companies following that strategy will be on solid footing, should the markets trade sideways or make a serious correction. Investors who banked their retirement savings on stocks that rode the wave of momentum to new highs could find themselves on unstable ground.

In the current market, momentum doesn’t really provide investors with high returns and low risk. It may sound boring, but the best way to find stocks with the greatest potential is to look for fundamentally solid companies making economically sound business decisions.

That’s good news for fundamental and technical analysts and bad news for those hoping to take a shortcut.

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