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

Revisiting the Reversal Revisiting the Reversal of Large Stock-Price of Large Stock-Price

DeclinesDeclines

Harlan D. PlattHarlan D. Platt

BreakdownBreakdown

Previous research and methodologyPrevious research and methodology DanielleDanielle

Overall resultsOverall results JonJon

Risk measure and comparing closing prices to Risk measure and comparing closing prices to daily lowsdaily lows JordanJordan

How often do companies appear on the list and How often do companies appear on the list and bid/ask spreadbid/ask spread DmitryDmitry

Previous ResearchPrevious Research

Most studies have found that investors Most studies have found that investors overreact to bad news and stock prices overreact to bad news and stock prices recover at least in part from large one-day recover at least in part from large one-day declinesdeclines

Other studies offer contradictory evidence Other studies offer contradictory evidence or argue that institutional factors such as or argue that institutional factors such as bid/ask spreads explain the findingsbid/ask spreads explain the findings


Psychological factors (loss aversion, herd Psychological factors (loss aversion, herd behavior) may influence investors to accept behavior) may influence investors to accept price levels below their true economic valueprice levels below their true economic value

Price reversal theoryPrice reversal theory Theory should be reevaluatedTheory should be reevaluated

In the past few years, minimum bid/ask spread In the past few years, minimum bid/ask spread differentials have shrunk from 1/8differentials have shrunk from 1/8thth of a dollar to 1 of a dollar to 1 centcent

Dramatic volatility of bull market run-up in 1990’s and Dramatic volatility of bull market run-up in 1990’s and bear market plunge in 2000-2001bear market plunge in 2000-2001


De Bondt and Thaler (1985) developed theoretical De Bondt and Thaler (1985) developed theoretical foundation of market overreactions: investors weigh new foundation of market overreactions: investors weigh new information more heavily than old informationinformation more heavily than old information

Found that over the 50-year span, lower portfolios outperformed Found that over the 50-year span, lower portfolios outperformed the market by an average 19.6% while winner portfolios the market by an average 19.6% while winner portfolios underperformed the market by an average 5.0%, 36 months underperformed the market by an average 5.0%, 36 months after portfolio formationafter portfolio formation

Atkins and Dyl (1990) found that bid/ask spread Atkins and Dyl (1990) found that bid/ask spread differentials misrepresented a price reversaldifferentials misrepresented a price reversal

Bremer and Sweeney (1991) found larger-than-expected Bremer and Sweeney (1991) found larger-than-expected positive rates of return, with returns accumulating over a positive rates of return, with returns accumulating over a 3-day horizon3-day horizon

Cox and Peterson (1994) found no price reversalsCox and Peterson (1994) found no price reversals

MethodologyMethodology

CRSP dataCRSP data January 1997-December 2001, about 1,250 January 1997-December 2001, about 1,250

trading daystrading days Reassessment of price reversals during a period of Reassessment of price reversals during a period of

declining bid/ask spreadsdeclining bid/ask spreads Prior research did not address market cyclesPrior research did not address market cycles

All NYSE and NASDAQ stocks that fit definition All NYSE and NASDAQ stocks that fit definition of a major price decline: core data comprised of of a major price decline: core data comprised of 20 worst-performing stocks every day on the 20 worst-performing stocks every day on the NYSE and NASDAQNYSE and NASDAQ

MethodologyMethodology

Examine short- and long-term price Examine short- and long-term price reversals over 7 time periods of 1, 3, 7, 30, reversals over 7 time periods of 1, 3, 7, 30, 90, 180, and 360 trading days after price 90, 180, and 360 trading days after price declinedecline

Assume beta = 1Assume beta = 1 Objective: To identify abnormal returnsObjective: To identify abnormal returns

Abnormal return = Individual stock return – Return on marketAbnormal return = Individual stock return – Return on market

Overall resultsOverall results

Price reversals provide substantial market Price reversals provide substantial market corrected short-term trading success on corrected short-term trading success on the NYSE and NASDAQthe NYSE and NASDAQ

This strategy does not work similarly well This strategy does not work similarly well for long-term investmentsfor long-term investments

The results when the 20 worst performing The results when the 20 worst performing stocks were bought……stocks were bought……


Price reversals consistently produce positive Price reversals consistently produce positive returns on an adjusted basis in the NYSE and returns on an adjusted basis in the NYSE and NASDAQ for investments held less than 8 daysNASDAQ for investments held less than 8 days

Bull markets have the same effect for up 7 daysBull markets have the same effect for up 7 days Bear marketsBear markets

Price reversal method in the NYSE beat the market Price reversal method in the NYSE beat the market for every holding periodfor every holding period

Only beat the market in the NASDAQ for holding Only beat the market in the NASDAQ for holding periods between 1 and 30 daysperiods between 1 and 30 days


20-worst performing stock list is then 20-worst performing stock list is then broken down into cohorts by percentage broken down into cohorts by percentage price declinesprice declines In both the NYSE and the NASDAQ, the In both the NYSE and the NASDAQ, the

higher the percentage decline, the lower the higher the percentage decline, the lower the average pricesaverage prices

For one-day holding period returnFor one-day holding period return• NYSE: stocks falling by less than 10% have best NYSE: stocks falling by less than 10% have best

returnsreturns• NASDAQ: stocks falling by less than 10% to 30% NASDAQ: stocks falling by less than 10% to 30%

have best returnshave best returns


List broken down by the prices of stocksList broken down by the prices of stocks Low priced stocks made up a higher Low priced stocks made up a higher

proportion on the list compared to the overall proportion on the list compared to the overall marketmarket

Average price and percentage decline are not Average price and percentage decline are not correlatedcorrelated

Even premier companies appeared on the list Even premier companies appeared on the list like Berkshire Hathawaylike Berkshire Hathaway

The lowest priced strata achieve the best The lowest priced strata achieve the best returnsreturns

Risk MeasurementRisk Measurement

Platt (2002 & 2005) argues that a portfolio of Platt (2002 & 2005) argues that a portfolio of equities that has just experienced a large price equities that has just experienced a large price decline has less risk than the market portfoliodecline has less risk than the market portfolio All company specific risk factors are revealed in news All company specific risk factors are revealed in news

announcementsannouncements

Two measures of portfolio risk may be used:Two measures of portfolio risk may be used: Standard deviationStandard deviation Semi-varianceSemi-variance


Standard deviation – square root of varianceStandard deviation – square root of variance

Semivariance- proportion of a portfolio’s Semivariance- proportion of a portfolio’s distribution of returns that lie in the negative distribution of returns that lie in the negative rangerange

• SV = 1.00 SV = 1.00 → strategy always makes money→ strategy always makes money• SV = 0.50 → equally likely to make or lose SV = 0.50 → equally likely to make or lose

money money Hedge funds / short term traders use semivariance Hedge funds / short term traders use semivariance

risk measurements because it takes into account the risk measurements because it takes into account the sign of the mean returnsign of the mean return

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


Platt theorizes that companies whose prices plunge in a Platt theorizes that companies whose prices plunge in a single day are more volatile than an average stocksingle day are more volatile than an average stock

Platt uses 50,000 stocks in the 5-year price reversal Platt uses 50,000 stocks in the 5-year price reversal portfolio comprising the 20 worst-performing stocks each portfolio comprising the 20 worst-performing stocks each day on the NYSE and Nasdaqday on the NYSE and Nasdaq

It is assumed the portfolio of 20 stocks on each market is sold on It is assumed the portfolio of 20 stocks on each market is sold on the following trading day and replacedthe following trading day and replaced

The market portfolio is represented by daily returns on The market portfolio is represented by daily returns on the S&P 500 for the NYSE, and the Nasdaq indexthe S&P 500 for the NYSE, and the Nasdaq index


The annual standard deviations are fairly consistent on the S&P indexThe annual standard deviations are fairly consistent on the S&P index The Nasdaq index showed large variations in 2000, 2001The Nasdaq index showed large variations in 2000, 2001

On average Nasdaq stocks are about 75% more volatile than NYSE stocks using On average Nasdaq stocks are about 75% more volatile than NYSE stocks using standard deviationsstandard deviations

Annual S.D.’s with price reversals are relatively constant over time on both Annual S.D.’s with price reversals are relatively constant over time on both marketsmarkets

Highest annual S.D. is just 30% greater than the lowest S.D. yearHighest 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% Compared to the market index is 40% greater for the S&P and 160%

greater for the Nasdaqgreater for the Nasdaq

Risk MeasurementRisk Measurement Kurtosis is the next moment of the distribution, measuring the Kurtosis is the next moment of the distribution, measuring the

stability of the variancestability of the variance A higher value indicates a tighter distribution of variances around its A higher value indicates a tighter distribution of variances around its

meanmean The Nasdaq and NYSE price reversal kurtosis is greater than their The Nasdaq and NYSE price reversal kurtosis is greater than their

respected indexrespected index Price reversals have more return volatility than the market portfolio, but Price reversals have more return volatility than the market portfolio, but

more consistency in the volatilitymore consistency in the volatility Price reversals gain some volatility due to large daily gains after Price reversals gain some volatility due to large daily gains after

suffering a large daily losssuffering a large daily loss The worst performing stocks on the NYSE fell on average 9.5%, The worst performing stocks on the NYSE fell on average 9.5%,

whereas an average stock had a price change of .04% whereas an average stock had a price change of .04% The worst performing stocks on the Nasdaq declined 16.4%, whereas The worst performing stocks on the Nasdaq declined 16.4%, whereas

an average stock had a price change of .07%an average stock had a price change of .07% After the event, the average price change for the price reversal portfolio After the event, the average price change for the price reversal portfolio

was .18% on the NYSE and 1.60% on the Nasdaqwas .18% on the NYSE and 1.60% on the Nasdaq

Comparing Closing Prices toComparing Closing Prices to Daily Low Prices Daily Low Prices

It is assumed that a stock is bought at the end of It is assumed that a stock is bought at the end of the daythe day This may distort the returns than an investor may earn This may distort the returns than an investor may earn

by investing at the daily lowby investing at the daily low

Traders using the price reversal strategy Traders using the price reversal strategy contend that on average fallen stocks increase contend that on average fallen stocks increase at the end of the day at the end of the day A more realistic assumption is that the position is A more realistic assumption is that the position is

acquired somewhere between the daily low and the acquired somewhere between the daily low and the daily closing pricedaily closing price

Comparing Closing Prices toComparing Closing Prices to Daily Low Prices Daily Low Prices

Platt tests this theory using the worst daily 5 stocks on Platt tests this theory using the worst daily 5 stocks on NYSE and Nasdaq in 2001NYSE and Nasdaq in 2001

1250 companies are studied in all1250 companies are studied in all 15.7% of NYSE and 11.9% of Nasdaq stocks closed at their 15.7% of NYSE and 11.9% of Nasdaq stocks closed at their

daily lowdaily low 12.2% of Nasdaq and 4.8% of NYSE stocks closed at least 10% 12.2% of Nasdaq and 4.8% of NYSE stocks closed at least 10%

or more above their daily lowor more above their daily low The difference between the closing price and daily low resulted 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 in a significant statistic of 2.8% on the NYSE and 4.0% on the NasdaqNasdaq

Platt’s results find that on average higher priced stocks Platt’s results find that on average higher priced stocks are more likely to increase intradayare more likely to increase intraday

This may be psychological as investors seek value and try to This may be psychological as investors seek value and try to minimize riskminimize risk

Stock appearance on the listStock appearance on the list

Not a significant difference between the Not a significant difference between the average number of times NYSE and average number of times NYSE and NASDAQ stocks appear on the listNASDAQ stocks appear on the list

Bid/Ask spreadsBid/Ask spreads Bid/Ask spread may account for some return Bid/Ask spread may account for some return

superiority for lower priced stocks at ~0.83% superiority for lower priced stocks at ~0.83% (NYSE) and ~0.80%(NASDAQ) given 1/16 (NYSE) and ~0.80%(NASDAQ) given 1/16 spread prior to ’94.spread prior to ’94.

Defense against the bid/ask hypothesis Defense against the bid/ask hypothesis 40% of the NYSE stocks that rose increased by 4.5%40% of the NYSE stocks that rose increased by 4.5% 39% of the NASDAQ stocks that rose increased by 39% of the NASDAQ stocks that rose increased by

8.0%8.0%

Bid/ask spread does not explain the entire effect.Bid/ask spread does not explain the entire effect. The spread now is $0.01 or less. Spread impact The spread now is $0.01 or less. Spread impact

is reduced at higher stock price levels.is reduced at higher stock price levels.

ConclusionsConclusions

Buying 20 worst performing stocks and Buying 20 worst performing stocks and then selling them one day later produces then selling them one day later produces adjusted annual returns of 32.50% on adjusted annual returns of 32.50% on NYSE and 387.50% on NASDAQNYSE and 387.50% on NASDAQ

Ideal holding period varies during bull and Ideal holding period varies during bull and bear marketsbear markets

Reduction of bid/ask spread did not Reduction of bid/ask spread did not reduce the approach returnsreduce the approach returns

Taking a step backTaking a step back

Stop loss orders to protect against a large Stop loss orders to protect against a large drop in daily price do not appear to drop in daily price do not appear to minimize the lossminimize the loss

A better alternative could be to close the A better alternative could be to close the position the next day after the large price position the next day after the large price dropdrop

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

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