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Revisiting the Reversal of Large Stock-Price Declines

A comprehensive analysis on stock price reversals, risk measurement, and market cycles. Explore market overreactions, psychological influences, and effective short-term trading strategies based on price declines.

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Revisiting the Reversal of Large Stock-Price Declines

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  1. Revisiting the Reversal of Large Stock-Price Declines Harlan D. Platt

  2. Breakdown • Previous research and methodology • Danielle • Overall results • Jon • Risk measure and comparing closing prices to daily lows • Jordan • How often do companies appear on the list and bid/ask spread • Dmitry

  3. Previous Research • Most studies have found that investors overreact to bad news and stock prices recover at least in part from large one-day declines • Other studies offer contradictory evidence or argue that institutional factors such as bid/ask spreads explain the findings

  4. Previous Research • Psychological factors (loss aversion, herd behavior) may influence investors to accept price levels below their true economic value • Price reversal theory • Theory should be reevaluated • In the past few years, minimum bid/ask spread differentials have shrunk from 1/8th of a dollar to 1 cent • Dramatic volatility of bull market run-up in 1990’s and bear market plunge in 2000-2001

  5. Previous Research • De Bondt and Thaler (1985) developed theoretical foundation of market overreactions: investors weigh new information more heavily than old information • Found that over the 50-year span, lower portfolios outperformed the market by an average 19.6% while winner portfolios underperformed the market by an average 5.0%, 36 months after portfolio formation • Atkins and Dyl (1990) found that bid/ask spread differentials misrepresented a price reversal • Bremer and Sweeney (1991) found larger-than-expected positive rates of return, with returns accumulating over a 3-day horizon • Cox and Peterson (1994) found no price reversals

  6. Methodology • CRSP data • January 1997-December 2001, about 1,250 trading days • Reassessment of price reversals during a period of declining bid/ask spreads • Prior research did not address market cycles • All NYSE and NASDAQ stocks that fit definition of a major price decline: core data comprised of 20 worst-performing stocks every day on the NYSE and NASDAQ

  7. Methodology • Examine short- and long-term price reversals over 7 time periods of 1, 3, 7, 30, 90, 180, and 360 trading days after price decline • Assume beta = 1 • Objective: To identify abnormal returns Abnormal return = Individual stock return – Return on market

  8. Overall results • Price reversals provide substantial market corrected short-term trading success on the NYSE and NASDAQ • This strategy does not work similarly well for long-term investments • The results when the 20 worst performing stocks were bought……

  9. Overall results

  10. Overall results • Price reversals consistently produce positive returns on an adjusted basis in the NYSE and NASDAQ for investments held less than 8 days • Bull markets have the same effect for up 7 days • Bear markets • Price reversal method in the NYSE beat the market for every holding period • Only beat the market in the NASDAQ for holding periods between 1 and 30 days

  11. Overall results • 20-worst performing stock list is then broken down into cohorts by percentage price declines • In both the NYSE and the NASDAQ, the higher the percentage decline, the lower the average prices • For one-day holding period return • NYSE: stocks falling by less than 10% have best returns • NASDAQ: stocks falling by less than 10% to 30% have best returns

  12. Overall results • List broken down by the prices of stocks • Low priced stocks made up a higher proportion on the list compared to the overall market • Average price and percentage decline are not correlated • Even premier companies appeared on the list like Berkshire Hathaway • The lowest priced strata achieve the best returns

  13. Risk Measurement • Platt (2002 & 2005) argues that a portfolio of equities that has just experienced a large price decline has less risk than the market portfolio • All company specific risk factors are revealed in news announcements • Two measures of portfolio risk may be used: • Standard deviation • Semi-variance

  14. Risk Measurement • Standard deviation – square root of variance • Semivariance- proportion of a portfolio’s distribution of returns that lie in the negative range • SV = 1.00 → strategy always makes money • SV = 0.50 → equally likely to make or lose money • Hedge funds / short term traders use semivariance risk measurements because it takes into account the sign of the mean return

  15. Risk Measurement • Ex. A dense population distribution with a negative mean return (A) is less risky using S.D. than a less dense distribution with a positive mean return (B)

  16. Risk Measurement • Platt theorizes that companies whose prices plunge in a single day are more volatile than an average stock • Platt uses 50,000 stocks in the 5-year price reversal portfolio comprising the 20 worst-performing stocks each day on the NYSE and Nasdaq • It is assumed the portfolio of 20 stocks on each market is sold on the following trading day and replaced • The market portfolio is represented by daily returns on the S&P 500 for the NYSE, and the Nasdaq index

  17. Risk Measurement • The annual standard deviations are fairly consistent on the S&P index • The Nasdaq index showed large variations in 2000, 2001 • On average Nasdaq stocks are about 75% more volatile than NYSE stocks using standard deviations • Annual S.D.’s with price reversals are relatively constant over time on both markets • Highest annual S.D. is just 30% greater than the lowest S.D. year • Compared to the market index is 40% greater for the S&P and 160% greater for the Nasdaq

  18. Risk Measurement • Kurtosis is the next moment of the distribution, measuring the stability of the variance • A higher value indicates a tighter distribution of variances around its mean • The Nasdaq and NYSE price reversal kurtosis is greater than their respected index • Price reversals have more return volatility than the market portfolio, but more consistency in the volatility • Price reversals gain some volatility due to large daily gains after suffering a large daily loss • The worst performing stocks on the NYSE fell on average 9.5%, whereas an average stock had a price change of .04% • The worst performing stocks on the Nasdaq declined 16.4%, whereas an average stock had a price change of .07% • After the event, the average price change for the price reversal portfolio was .18% on the NYSE and 1.60% on the Nasdaq

  19. Comparing Closing Prices to Daily Low Prices • It is assumed that a stock is bought at the end of the day • This may distort the returns than an investor may earn by investing at the daily low • Traders using the price reversal strategy contend that on average fallen stocks increase at the end of the day • A more realistic assumption is that the position is acquired somewhere between the daily low and the daily closing price

  20. Comparing Closing Prices to Daily Low Prices • Platt tests this theory using the worst daily 5 stocks on NYSE and Nasdaq in 2001 • 1250 companies are studied in all • 15.7% of NYSE and 11.9% of Nasdaq stocks closed at their daily low • 12.2% of Nasdaq and 4.8% of NYSE stocks closed at least 10% or more above their daily low • The difference between the closing price and daily low resulted in a significant statistic of 2.8% on the NYSE and 4.0% on the Nasdaq • Platt’s results find that on average higher priced stocks are more likely to increase intraday • This may be psychological as investors seek value and try to minimize risk

  21. Stock appearance on the list • Not a significant difference between the average number of times NYSE and NASDAQ stocks appear on the list

  22. Bid/Ask spreads • Bid/Ask spread may account for some return superiority for lower priced stocks at ~0.83% (NYSE) and ~0.80%(NASDAQ) given 1/16 spread prior to ’94. • Defense against the bid/ask hypothesis • 40% of the NYSE stocks that rose increased by 4.5% • 39% of the NASDAQ stocks that rose increased by 8.0% • Bid/ask spread does not explain the entire effect. • The spread now is $0.01 or less. Spread impact is reduced at higher stock price levels.

  23. Conclusions • Buying 20 worst performing stocks and then selling them one day later produces adjusted annual returns of 32.50% on NYSE and 387.50% on NASDAQ • Ideal holding period varies during bull and bear markets • Reduction of bid/ask spread did not reduce the approach returns

  24. Taking a step back • Stop loss orders to protect against a large drop in daily price do not appear to minimize the loss • A better alternative could be to close the position the next day after the large price drop

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