When investing, you’ll realize that technical and fundamental cues can often lead to debate. One of the most debated indicators is the 52-week high. When a stock’s price begins to near its 52-week high, investors begin to wonder if they should buy or sell.
The buy-or-sell question seems like a pretty simple one, but there’s quite a bit to answering it.
Some investors refuse to buy at or around 52-week highs because they see these points as strong resistance points, signaling that the stock will fall. Others jump on the opportunity to get in on a stock that’s moving up, hoping that the 52-week high will be breached and significant growth is ahead.
But who’s right?
Effect of 52-Week Highs on Stocks
The 52-week high is an important technical indicator that means big movement is likely on the horizon. If a stock breaches its 52-week high, there’s a strong chance that significant gains are ahead. Conversely, if the stock fails to break through its 52-week high, significant declines may be ahead.
Understanding Support and Resistance
The best investors not only have a great understanding of the stock market as a whole, they have a great understanding of the human mind, including their own. Investing is a highly psychological action — one where emotions can take hold and ravage a portfolio’s earnings. So, what’s the psychological importance of the 52-week high?
The answer involves two of the most basic of technical indicators: support and resistance.
When a stock goes on a winning streak, hitting high levels, and then reverses, the highest price the stock achieved is known as resistance. At the point of resistance, the investing community believes that the value of the stock has reached or exceeded fair market value, and prices are going down ahead.
On the other hand, when a stock is on a losing streak, reaches the bottom, and then reverses, the lowest price reached is known as support. This is the point at which the investing community believes the stock has fallen so far, and it can only go up.
Support and resistance have nothing to do with fundamentals. The new product, management, or plan being launched by the underlying company represented by the stock has nothing to do with them. At these levels, investors seem to set fundamentals to the side, often making purely technical decisions based on the basic human emotions known as fear and greed.
The 52-week high is the point of resistance over the past year, and the 52-week low is the point of support over the past year.
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Share Price and the 52-Week High
When nearing a 52-week high, or trading on 52-week highs, the stock obviously must have headed upward. History has taught us that when a stock is trending upward, it will continue to do so — that is, until it reaches resistance.
Knowing that 52-week highs are the strongest point of resistance that a stock has seen over the past year, some investors become nervous. After all, prices tend to fall when they reach historic resistance levels.
This fear creates a psychological barrier, preventing many investors from buying shares. In some cases, this fear of loss is so strong that some investors who own shares nearing their 52-week highs sell some or all of their position in the stock.
This creates a bit of a conundrum.
Stocks don’t just decide to reach 52-week highs for no reason. In the vast majority of cases, good news has been released and investors are excited about the future. Oftentimes, highs are the result of improved sales, increasing profits, and strong future prospects for more of the same.
With this kind of good news causing an upward trend, the fact that you’ve been told never to bet against the trend tells you to buy. On the other hand, you’ve learned how buying at resistance can devastate your returns. So, what do you do? Do you stay clear and risk missing the chance of achieving significant gains — the definition of FOMO — or do you buy and risk a costly reversal?
This conundrum keeps prices compressed as fearful investors steer clear of adding to or opening positions around resistance. Nonetheless, 52-week highs have historically been a positive signal.
Although emotions surrounding technical signals hold stocks down at the 52-week high for a short period of time, if the underlying company’s fundamentals are strong and recent news has been positive, the battle between the bears (those who believe the stock will fall) and the bulls (those who believe the stock will rise), is often won by the bulls.
Once the 52-week high is broken, be prepared for a big run in value.
In general, when resistance is broken, investors get excited. Those who held off for fear of a reversal begin to buy, leading to a large increase in share volume and price. When the 52-week high or 52-week resistance line is broken, the positive reaction is exacerbated. The increase in buying and significant gains that follow a bullish break through the 52-week high are the result of two key factors:
- Visibility. Reaching a 52-week high is a big achievement for a stock, and the levels of support and resistance at 52-week highs and lows are strong. As a result, the investing community heavily tracks stocks nearing or which have hit their 52-week highs. In fact, there are several stock investment research websites that pour quite a bit of resources into creating lists of stocks that are near or have reached this point. Because investors track this so closely, and 52-week high lists are publicized by big names like Nasdaq and The Wall Street Journal, these stocks enjoy increased visibility, which organically increases buying.
- FOMO. The other side of the equation is fear of missing out, or FOMO. History suggests that if a stock breaks past its 52-week high, it will outperform the overall market ahead. The fear of missing out on the potential to beat the market leads to further increased buying.
It’s important to keep in mind that everything said above is based on averages. Stocks — even stocks trading on 52-week highs — don’t all behave the same way. In general, stocks that trade past their 52-week highs tend to outperform the market, but there are no guarantees. So, the fact that a stock is trading at this level should not be the sole reason for your investment.
Analyzing the 52-Week High Effect
In 2008, Steven Huddart, Mark Lang, and Michelle Yettman published the first paper finding a correlation between market capitalization and market-beating returns when a stock crosses its 52-week high.
According to the paper, small-cap stocks that crossed their 52-week high generated a further excess in gains over the market’s overall performance than stocks with large market caps. In fact, in the month following a 52-week high breach, small-cap stocks produced 1.8963% excess gains when compared to the overall market, while large-cap stock excess gains after a month were just 0.6275%.
Regardless of the market cap, the paper suggested that the largest gains were experienced in the week following the breach of the 52-week high. Excess gains in the weeks following the breach tapered off at about the same rate, regardless of market cap.
Although there hasn’t been new research on the topic since that paper was published more than a decade ago, it’s easy to see that the conclusion of the paper still seems to hold true. In fact, several experts follow a trading strategy under which they purchase small-cap stocks at or just above 52-week highs that have strong fundamentals. The excess gains that these experts generate are either directly or indirectly related to the research originally done by Huddart, Lang, and Yettman.
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Other Effects and Findings Associated With 52-Week Highs
There have been several research reports showing just how useful a 52-week high is to an investor. Some of the most notable findings include:
52-Week Highs Provide Valuable Information
In their paper published by the Auckland Center for Financial Research, Li-Wen Chen and Hsin-Yi Yu found that nearness to the 52-week high and the 52-week low, as well as past returns, suggest the presence of unpriced information. The study also found that a trading strategy based on nearness to the 52-week low provides an excellent hedge for the momentum strategy.
This research suggests that if you’re using a momentum trading strategy, hedging your bets with stocks close to their 52-week low is a great way to reduce risk and maximize profit potential. Also, nearness to the 52-week mark suggests that there is valuable, unpriced information that will ultimately lead to gains in the value of the stock.
Sector Strength Matters
In a paper published by the Social Science Research Network (SSRN), researchers Xin Hong, Bradford Jordan, and Mark Liu found that the outperformance of stock at their 52-week high was heavily correlated to sector performance. Their report showed that when an entire sector nears its 52-week high, individual stocks within that sector are likely to see excess gains that are higher than stocks that breach 52-week highs in a mixed or downtrodden sector.
This research suggests that it pays off to pay attention to the performance of the entire sector when you invest using a 52-week trading strategy. By focusing on stocks that are hitting their 52-week highs while their underlying sector is experiencing similar strength, you have the ability to significantly increase your gains.
It’s Time for a Buyout
Malcolm Baker, Xin Pan, and Jeffrey Wurgler came to another interesting conclusion in their paper, “A Reference Point Theory of Mergers and Acquisitions.” Their research found that the 52-week high is the most common merger or acquisition buyout threshold price. If a buyout offer is higher than the 52-week high, the target company is more likely to accept the offer.
The research suggests that if you’re following a company that has received a buyout offer, you should pay close attention to the 52-week high. If the offer price is above the 52-week high, the company you’re interested in is likely to accept the offer. As such, an investment in the company prior to the potential acquisition comes with a chance to get your hands on significant gains.
Cause of 52-Week High Excess Gains
Why is it that when a stock breaks through its 52-week high, it’s likely to see significant gains that outpace those of the overall market? Well, it all goes back to the basic human emotions of fear and greed.
Buying a stock near resistance adds to the level of risk you accept when you make the purchase. As a result, when stocks are near this point, positive news is often underpriced in market reactions as investors fear a reversal ahead.
When solid fundamentals and positive news persist, and the stock breaks through the 52-week high barrier, greed starts to take over. There’s a strong chance that history will repeat itself and the stock will climb. Investors don’t want to miss out on this, leading to an influx of buying. At this point, recent news is often overvalued, leading to a short-term significant run in value.
However, it’s important to keep in mind that excess gains generated by 52-week high breaches don’t last forever. Although excess gains are generally experienced for a month or two, over time, the growth can slow significantly, leading to a long-term underperformance when compared to the overall market. As a result, even if you buy a stock just before or just after it breaches the 52-week high, it’s important to pay close attention to the performance of that stock over time.
Beware the Bubble
A 52-week high is often an accurate indicator for compelling future performance. As Hong, Jordan, and Liu pointed out, the indicator is even more accurate when applied to the entire sector as you make your stock picks. However, the 52-week high can be deceiving.
Never buy a stock just because a stock is trading at or above its 52-week high.
When a group of stocks consistently forms new 52-week highs for a long period of time, it’s a sign of danger. The same phenomenon occurred during the dot-com bubble. Everything was going well for any company related to the new World Wide Web. Stocks across the sector were minting new 52-week highs almost daily. Investors were riding on highs.
Then, the bottom fell out of the dot-com market.
The burst of the dot-com bubble wiped massive amounts of money out of the United States stock market, devastating the portfolios of countless investors. It was a painful time.
The same thing is currently being seen with COVID-19 stocks. Companies that never considered creating vaccines or personal protective equipment are suddenly in the booming space, accepting billions of dollars of investor money and grants.
As a result, COVID-19 stocks are breaking into new 52-week highs on what seems to be a daily basis. While there are great companies in the sector, the vast majority are benefiting from investor greed in what is beginning to become a bubble. As a result, investing in this space without adequate research can become overwhelmingly costly when the bubble bursts.
Always Do Your Research
When following trends that generally lead to gains, beginner investors often forgo additional research prior to making their investments. This is a big mistake, whether making an investment based solely on the 52-week high indicator or on any other single indicator.
Expert investors who make the big bucks in the market do so by going through a research process known as due diligence. Every investor’s due diligence process is different, as different factors may hold more or less value to some investors than others, but following through on your due diligence is crucial.
It’s true that, most of the time, when a stock breaks past its 52-week high price, significant gains are to follow — but that’s most of the time. There are thousands of stocks. At any given time, tens or even hundreds of them will be nearing, breaking, or will have recently broken through 52-week highs. The majority of the stocks that break the resistance barrier will go on to generate gains. Some will not.
Ensuring that the company you’re investing in has strong fundamentals, recent positive news, and a real potential to generate growth beyond breaking its 52-week high is the best way to make sure that you make winning investment decisions when using a 52-week high strategy.
Investing in stocks that recently surpassed their 52-week highs is an exciting process. These stocks are often big winners that give investors the opportunity to beat the market.
However, while there are plenty of roses in this bush, there are also plenty of thorns. You wouldn’t pick a rose off of a rose bush without first checking for thorns, and you shouldn’t pick a stock trading on 52-week highs without doing your research first.
Nonetheless, if you do your research and make educated investments in stocks trading at or above 52-week highs, you have the potential to realize significant returns.
How does nearness to 52-week highs help you determine whether or not to invest? Do you also track 52-week lows?