Why high-flyers can still outperform

With many indices and stocks nearing 52-week or all-time highs it is timely to discuss some of the unique factors that dominate this phase of the cycle.

William O’Neil, founder of Investor’s Business Daily and one of the top selling investment authors of all time, once said, "The hard-to-believe Great Paradox in the stock market is what seems too high in price and risky to the majority usually goes higher eventually, and what seems low and cheap usually goes lower."

The answer lies in understanding the impact of psychology, especially the greater role it plays in stocks nearing or at all-time highs.

While the traditional analyst or economist looks for fundamental based projections and overall growth rates to justify such lofty prices and hence predict further price action, research suggests that there is a different approach that can be more reliable in predicting price action. It suggests that investors should treat the market like a game of poker, in that they are up against other player’s perceptions of what is happening or is going to happen.

With this in mind, the question to ask is ‘who is in more pain?’

Is it the investors who are long? Is it those who are short? Or is it those who don’t even hold a position? Understanding this will help one’s investing considerably.

There are three psychological forces trying to push prices higher versus only one potential force trying to reverse the trend.

Firstly, when a stock is near or at new highs, everyone who is long is sitting pretty. At all-time highs every single person that ever bought the stock is showing a profit.

Secondly, those who are short are more than likely feeling considerable pain, meaning that sooner or later, they’ll buy back their short positions, adding further fuel to upside momentum.

Thirdly, you have those people suffering from FOMO (fear of missing out). These are the ones who coulda, shoulda, woulda, but didn’t. Sooner or later, the pain gets too much and they buy long positions as well.

So, against all this buying you have the sellers. They are the ones who don’t believe the current price is justified, be it for whatever reason. Their selling is the only force working against higher prices. History tells us that for the majority of cases, this selling pressure is no match for the buying forces.

Let’s compare this scenario against stocks that have huge overhead resistance or are trading well below their 52-week or all-time highs. When investors start showing a loss on a position, irrational behaviour starts to dominate the decision-making process and it becomes worse as the loss grows. This results in the overwhelming urge to exit at breakeven at best, or minimise losses at all costs.

When a declining stock finally starts to move higher it has to fight through this huge supply of selling pressure. Every time it gets to a higher level, a new wave of selling emerges from those whose only goal is to breakeven. This consistent selling pressure explains why it is so much easier for stocks at 52-week or all-time highs to outperform.

Ben Potter is the Retail Editor at Baillieu Holst Ltd.