At the very heart of Trend following is the concept of buying at new high with the assumption being that market knows something that we don’t. While the logic works on literally all time frames and tickers, some are better suited than others. Indices for example are better suited than even its Individual components, Commodities better than the End Users among others.
In bull markets such as the one we are currently in, every day you see a large list of stocks that are hitting new highs and vice versa when the markets are bearish. The chart below plots the sum of All stocks that hit new 52 week highs subtracted by All stocks that hit 52 week lows. As you can see, its been bullish (though not overly we we saw in 2014) for quite some time now.
Buying at a new high is tough mentally speaking. After all, you have witnessed a rally (that you may or may not have participated in) and its normal to wonder whether one is too late to enter. Nifty 50 for example is 26% above its 52 week low which got posted just a few months ago (29th Feb 2016). The question hence is, after missing out of that 26% move, does it make sense to commit now especially when analysts are calling the market as being highly over-valued and primed to fall.
Spreading fear is easy in markets, after all, markets do tend to move higher at a very slow pace but fall precipitously when we hit a speed breaker. Nifty 50 hit its first 52 week high (based on look back of 240 days) after having previously hit a 52 Week low on 25th July 2016. So, lets take a look at what history says has happened when Nifty 50 hit its first 52 Week High.
The above table is a list of dates when Nifty 50 hit a new 52 week high and what happened later on. The last column showcases the returns between when it hit its first 52 week high and the return at the time when it hit a new 52 week low. Even ignoring that, what the table above suggests is that save for 1997, markets have provided positive returns in the days and months ahead.
Lets also look at the same table but when markets hit a new (first time) 52 week low.
Surprise, Surprise. Buying the new 52 week low isn’t as bad (if you could have withstood the draw-down) as it sounds in theory. But as with anything else, we have a problem and the problem is that there isn’t really sufficient data to draw conclusions we want to draw upon. Yes, we are using around 20 years of data, but our data points are too few to provide us with a realistic view.
Given that we are wanting to test our theory, there is no better way than to use the same logic on the Dow Jones Index which has around 120 years of data to back it up. What is the outcome if we test the same concept there.
First, lets start with data of what happened when Dow hit a new 52 week high.
And now, the same when Dow hit a new 52 week low.
Unlike the data of Nifty 50, here with more data we can easily see why it makes more sense to buy a 52 week high than buying a 52 week low.
On 4th June of this year, I wrote a blog post titled “Start of a New Bull Market?” where I showcased why I felt this was maybe a start of a new bull run. As on date, we are up around 6% and I do feel we have some distance to go before we crash. But then again, no one knows the future and the only way to go is to work with probabilities and know all the exit doors in case the trend doesn’t go as we anticipate it will.
