Long before the saying “BTFD” emerged on Wall Street as a result of some $13 trillion in central bank liquidity injections (now rapidly unwinding as a result of the failure off the Petrodollar and the so-called Quantitative Tightening) which made corrections impossible if not yet illegal, the phenomenon of buying sharply falling stocks had a different name on Wall Street: “catching a falling knife” (alternatively “dash for trash”).
And yet, absent a functioning global central bank does it pay to catch falling knives? That is the topic of the latest analysis by SocGen’s Andrew Laphtorne, whose conclusion is bound to disappoint thousands of 20-year-old hedge fund managers whose only “edge” is to buy whatever is most red on any daily heatmap.
But before we get to the conclusion, a quick look at this fascination with “catching bottoms.” As Lapthorne writes, in the retail industry “there is a whole sphere of psychological research dedicated to exploiting our fondness for a bargain. From overpricing items to begin with, only then to discount them, to placing them next to more expensive assets, to bundling items together to give the impression you are getting more for less. ‘Black Friday sales’ type events are essentially there to exploit our weakness for an apparent bargain, to the extent that the thrill of getting a bargain is emotionally more important than the actual pleasure you derive from the underlying item itself. Steep price declines in equities markets can create such emotions.”
According to Wikipedia, anchoring is “the tendency to rely too heavily, or “anchor”, on one trait or piece of information when making decisions (usually the first piece of information that we acquire on that subject),” and in the world of investing that piece of information tends to be price. So just as a bargain hunter in a sale will see “value” if the sale price is significantly different to the pre-sale price, so investors will get excited about big price declines relative to recent history. This effect has profound effects. Witness the near 25% bounce in UK Mining stocks in the last few days. When faced with an index that has fallen some 60% in the space of a year, you can’t help thinking of the potential 150% upside to the old price. We’ve all done it. Maybe it was gold, or biotech stocks, or Apple… It’s in our DNA.
So faced with a whole bunch of stocks trading significantly down from their highs, many investors will sense an opportunity to pick up bargain. But as investors our job should then be to try to curb that instinct and seek alternative and more useful information. An obvious starting point, which we aim to address here, is to ask the simple question: does it make sense to buy stocks simply because they have fallen a lot.
Lapthorne then analyzed the performance of buying “falling knive” portfolios over time. This is what he found.
We start our analysis with a simple exercise, where we look at the relative performance of a strategy that buys companies that have seen 1) 20%, 2) 30%, 3) 40% and 4) 50% declines from their 12-month peak. As our portfolios might only include a handful of companies in some periods, we only take into account periods where we have at least 20 companies, and otherwise we assume a zero return. All portfolios are then rebalanced on a monthly basis, and our universe is based on FTSE World stocks since 1990.
As the chart below shows, despite some periods of strong outperformance (these periods are often referred to as the “dash to trash”), all portfolios eventually underperformed the market.
Maybe the performance better over longer holding periods? Again, No.
We also wanted to look at the performance of the different portfolios across longer holding periods as you might think that given the price declines these stocks have seen, it will take a longer time period for them to recover. Still we find relative performance to be consistently negative for the longer holding periods as well. The chart below shows holding periods up to 1yr, and we have actually looked at even longer periods and observed a very similar pattern.
Another thing we checked is each stock’s performance relative to their sector and country as often distress is associated with particular countries or sectors and hence our portfolios historically will probably see heavy biases versus the universe portfolio (for example energy stocks today). So, it could be argued that while distress stocks show poor performance versus the market, they fare better versus their country or sector peers. This seems not to be the case, for while we see some improvement in the relative performance, it still remains negative across all the holding periods.
According to the SocGen strategist, when markets move downwards, i.e., when there is a broad selloff, the “falling knives” portfolio sees even worse performance with an excess return of ~-17% and a hit ratio (i.e. percentage of periods that the has outperformed the market) of close to 0% on a forward 1-year basis. Perhaps more surprising is the performance of SocGen’s portfolio in up-markets, where one would expect the portfolio to perform better and produce strong relative performance. Instead, while overall the excess performance is positive, it is only by less than 2% with hit ratios of around ~50%.
In summary, according to Lapthorne, “it is obvious that the upside versus downside payoff of ‘falling knives’ is not very enticing for even the bravest investors. There is a significant penalty to pay in case you get the timing wrong and the actual upside is very limited.”
So is all lost for BTFDers? There is one exception: while it doesn’t pay to buy falling knives, as “rarely do those stocks that lead us down into a slump provide the best performances on the return back up, and as such investing in ‘falling knives’ is a bad idea”, this strategy does seem to work in one specific case: if one ties this performance to the absolute proportion of beaten up stocks within the market in any given month. “That is to say if the whole market is cheap, the strategy seems to work.” Also “if we select and buy the cheapest stocks in valuation terms within this universe, the strategy also works. So it would appear that bargain hunting can work, just make sure the share price is not your only guide.”
So the last question: is the market cheap enough to where buying falling knives could potentially work? Lapthorne one final time:
Despite last month declines, valuation dispersion has been so depressed in recent years that it still sits slightly below average on a global basis. It has risen quite fast recently but the current level still does not look very attractive, particularly given where the absolute level of equity valuations remain today and the deteriorating global macro environment
Dip buyers: you have been warned.
via Zero Hedge http://ift.tt/1TZm8Y2 Tyler Durden