The Reversal Effect

Over the weekend I sat down with my preteen boys and watched Planet of the Apes. No, not the 21st century version. We watched the 1968 classic starring Charlton Heston and Roddy McDowall. Afterwards, our conversation stirred about the plausibility of apes being the dominant species and humans as caged, mute creatures. As they continued the discussion on their own, I started thinking about how this topsy-turvy simian world related to stock investing. No, really, I did. Here's what I came up with.

Applying the upside-down theory to stocks, I asked myself the following questions. Are high flying stocks poised for a fall? Do the prices of beaten-down stocks rebound after a period of time? In essence, is there a reversal effect in the stock market, and what is the time frame one needs to consider?

Recall my previous piece on the Momentum Anomaly, which indicated that winners over the last 52 weeks continue to outperform. But is there a point of inflection or reversal within that 52 week period?

Being the sleuth that I am, I set out finding answers to these questions. Starting with a universe of the largest 3000 stocks, I ran tests from January 2000 until July 2011 by building portfolios based on each of these price-change strategies. Since I don't like investing in poorly-rated companies, I excluded stocks rated as either "sell" or "strong sell" per the Zacks Rank. The subsequent average annualized returns and standard deviations are below:

These results show that the stocks with a high 4 or 1-week price change on average under-perform the selection universe, while stocks with a low 4 or 1-week price change outperform. So you want stocks with higher long-term (12+ week) momentum or lower short-term (1-4 week) momentum.

What happens if you combine long term momentum with short term reversal?

The best strategy is the one that buys the stocks that had a pretty good run over the last year, yet experienced a pullback over the last week. That makes good sense and allows you to pick up the stock at a cheaper price before it continues its run.

Be aware, however, that momentum and reversal strategies often experience higher volatility than the market. In spite of this, the combination of both long-term momentum with short-term reversal greatly reduces this volatility overall.

Here's a method for finding stocks to take advantage of long-term momentum and short-term reversal:

• First, start with only US common stocks.
  
• Next, create a liquid, investible set of the stocks with the largest 3000 market values and average daily trading volume greater than or equal to to 100,000 shares (if there's not enough liquidity, it'll be hard for you to trade it).
  
• Add another filter by selecting those stocks with a Zacks Rank less than or equal to 3. (Let's be clever and avoid the poorly-rated stocks.)
  
• Select the top 100 stocks with the highest return over the past 52 weeks.
  
• Finally, of those 100, select the 10 stocks with the lowest return over the past week.

Here are 5 great stocks based on this idea (10/5/11):

( CVI - Snapshot Report ) - CVR Energy, Inc.

CVR Energy refines and markets transportation fuels in the US. In August, CVR reported record quarterly results. Hedge funds are buying this stock, which remains a good value for its price.

( SCSS - Snapshot Report ) - Select Comfort Corporation

Select Comfort manufactures, markets and distributes adjustable-firmness beds. Select Comfort has been growing in every way (sales, income, margins, cash flow) and investors feel there's room for even greater growth.

( WFM - Analyst Report ) - Whole Foods Market, Inc.

Whole Foods owns and operates natural and organic food supermarkets. Trends in healthy eating have boosted profits for this grocer.

( HLF - Snapshot Report ) - Herbalife Ltd.

Herbalife sells nutritional supplements, energy, sports fitness and personal care products worldwide. Profit growth has been strong and has led to outstanding fundamentals at this company.

( XTXI - Snapshot Report ) - Crosstex Energy Inc.

Crosstex Energy engages in gathering, transmitting, processing and marketing natural gas. Insiders have bought millions of dollars in stock of this company. Take a guess which direction they think this stock is heading.

Finally, here's some great news if you want to learn more about the reversal anomaly as well as other anomalies. The Handbook of Equity Market Anomalies has just been released and it details several winning strategies used by investment pros. You can also learn more about various market anomalies by visiting a website dedicated to their explanation and discussion: http://hema.zacks.com/.

Happy Investing!