Bottom Fishing

Most finance academics believe in the “efficient market hypothesis,” which teaches that past stock price changes provide absolutely no information for forecasting future price changes. But just how true is this theory in practice? Is bottom-fishing really a viable strategy?

Fortunately, stock price data is readily available for analysis. Schwab’s equity research team has extensively studied the relationship of historical stock price changes to future stock price changes in markets around the world.

For the purposes of this article, we took the 3,000 largest U.S. stocks by market capitalization each month from 1990 to 2007 and divided them into five uniform portfolios, according to their price changes over the prior 12 months. We then measured portfolio returns over subsequent six-, 12- and 24-month holding periods relative to the 3,000-stock-universe average.

Are stocks that have performed poorly over the past year potential bargains? The graph “Give the Deep Divers Time to Resurface” reveals that the answer depends on your time horizon. Let’s focus on Portfolio 5: the 20% of stocks with the weakest past performance, underperforming the average stock by 30% or more over the prior year. Note: On average, Portfolio 5 stocks continued to underperform for the first six months after portfolio formation, but then eventually reversed and outperformed over a longer 24-month holding period.

This pattern suggests that investors tend to initially underreact to whatever caused the poor performance over the previous year, but then eventually overreact—leading to potential market-beating opportunities for bottom-fishing investors with a longer-term focus.

As a quick aside, these results certainly throw some cold water on the efficient market hypothesis. Past price performance trends tend to persist for holding periods up to six months, which suggests that price momentum can be a useful indicator for active traders.