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A bullish signal

A share price close to a 52-week high can be a predictor of good returns.
December 18, 2009

At just under 5500, the FTSE 100 is only slightly below its 52-week high, of 5600. Any rise from now could be a bullish sign. This might sound like technical analysis nonsense. But it's not. New research shows that a price's 52-week high matters more than you'd think.

Jun Li and Jianfeng Yu of the University of Minnesota have shown that when the FTSE 100 is near its 52-week average the index is more likely than not to do well over the following six months. The same is true for the Dow Jones industrial average.

The reason for this is that investors sometimes tend to under-react to good news, causing shares to be under-priced. In this context, the 52-week high matters in two senses.

First, if a price or index is near this level, it's a sign that it has recently enjoyed some good news. That means there's a chance the market has under-reacted.

Secondly, a price some way below the 52-week high represents familiar territory from which investors are reluctant to stray far; in this sense, technical analysts are actually right - the 52-week high can act as a barrier. To change the metaphor, a price below its 52-week high acts as a psychological anchor which tends to hold prices back.

This anchor can cause an asymmetry when prices are close to their 52-week high. If we get bad news those investors who have under-reacted to earlier good news stick to their bearish Bayesian priors and think: "I knew it." Prices don't therefore change much. However, if we get good news, there's more chance they'll be surprised and will have to update their beliefs. As a result, prices could rise more.

So, when technical analysts say that a breakthrough a resistance around a price's 52-week high is a bullish signal, they are not necessarily talking rot.

But are investors really so irrational as to pay attention to what is, essentially, an irrelevant number?

Yes, according to other research by Matthew Baker of Harvard Business School. He's studied takeovers in the US. And he's found that firms bidding for others are more likely to offer the target company's 52-week high price than any other price. And the probability of an offer being accepted rises sharply if it is above the 52-week high.

Even in investments where the stakes are highest - which should (in theory!) be made with the greatest thought - the 52-week high matters.

There is, though, a caveat here. Although nearness to a 52-week high is a statistically significant predictor of future returns it is not - of course - a foolproof one. It can, estimate Messrs Li and Yu, explain only around one-eighth of the variation in six-monthly returns. This is, then, only a small reason to be bullish. But is should, slightly, weaken the probability to attach to low returns.