>big stock effect. Research on portfolio returns by Andrew Lo and Craig Mackinlay, using a mixture of small and large capitalization companies on the New York Stock Exchange, showed there was a correlation between one weeks return and the next, where around ten-percent of the price change of next weeks return could be predicted from this weeks return. Though the effect only works for portfolios, not for individual stocks, and only in the short-term - that is, daily and weekly returns - there appears to be an observable lead/lag pattern. Which means, big stocks lead little stocks, hence the name. For example, Microsoft goes up dramatically and a few days later there’s a price jump in other computer software manufacturers.

Consequently, buying second line stocks - mid caps and small caps - in a sector believed to be ready for a re-rating sometime in the near future, and then sitting on the investments patiently, can work very well. Though money can be made here purely from momentum effects, my preference is for a portfolio that’s financially sound and less likely to be buffeted arou

Overreaction is probably the most popularly known effect of human behavior on market prices. All things being equal, in a rational market the fundamentals of a company should determine its market price, and there should be a clear relationship between the two. However, research - as well as a casual glance at CNN's stock-ticker on any given day - shows that this relationship doesn't necessarily happen as expected.

Investors regularly overreact, often wildly, so pushing prices up too high or pushing them down too low against their fundamentals. Not only is the market, therefore, not wholly rational in reality, but the effect cannot be attributed to any financial or company-based factor. The most likely reason for the anomaly appears to be the way investors perceive, and react to, earnings surprises or news items, or indeed other investors' actions. This overreaction occurs across the stockmarket and gives rise to several investment strategies.

Contrarian Strategies

The overreaction effect is highly pronounced when comparing 'out of favor' (contrarian stocks) against current 'favorites', or what are also known as value and glamour stocks. 'Out of favor' stocks are not stocks that are bad quality stocks, simply ones that are not attractive to the market, for whatever reason that might be. The interesting thing is, however, that over time the 'out of favor' stocks will, in general, outperform the 'favorites'. Then, when the 'out of favor' stocks become the 'favorites' due to increased buying the effect is reversed and the process is repeated in a cyclical manner, while only minor changes may take place to the stock's fundamentals. 'This occurs,' says David Dremen, who researched the effect with a portfolio of stocks over a ten year period, 'because these stocks will tend to reverse over time as investor expectations change'. Premiums paid for high growth stocks become too expensive while 'out-of-favor' stocks begin to represent greater potential gains. The effect is reminiscent of regression to the mean, a statistical effect where measurements will tend towards their average, and is in fact nothing new. Scientists have known for several hundred years that this kind of effect often occurs when human behavior is involved. What is new is that the effect has been found to occur within a particular domain of stocks.

Whether a stock is an 'out of favor' or 'favored' stock is indicated by their ratios. According to James O'Shaughnessy, whose extensive and well-researched findings were published in What Works on Wall Street, these include: price to book value (P/BV), price to cash flow (P/CF), and price to earnings (P/E). Stocks with the lowest ratios have the most potential to rise, particularly on good news surprises, and are therefore the ones, from this contrarian perspective, that should be sought after, providing they are essentially good stocks.

Momentum Strategies

Contrarian investing would seem to indicate that making money in the stockmarket, over and above the smaller but consistent returns from well-known companies like Microsoft or IBM, requires buying only 'out of favor' or value stocks. However, this is not the case. Indeed, if one were to take this to its logical conclusion no one would buy rising stocks - that were on their way to becoming glamour stocks - and profitable opportunities would be missed. In addition, value stocks take an average of five years to show a worthwhile return. Clearly that is often unacceptable and research bears out, in fact, that momentum pushes many stocks towards new heights regularly, and money can be made on these stocks considerably faster than five years. This doesn't mean that you simply buy any stocks that are rising away from their rational price due to market or behavioral influences. Such an approach would be unsystematic and likely to result in a loss. Although, as Robert Vishny points out, 'You don't necessarily make money on the best stocks in the market but on the stocks everyone thinks are going to be the best'. The rider here, of course, is that you still need to buy stocks that are good or potentially good, even though they may not be the best. Inasmuch as this is true, and you can locate these stocks, there are two momentum strategies that can be implemented.

The first strategy applies to combinations of stocks, and makes use of what is known as the big stock effect. Research on portfolio returns by Andrew Lo and Craig Mackinlay, using a mixture of small and large capitalization companies on the New York Stock Exchange, showed there was a correlation between one weeks return and the next, where around ten-percent of the price change of next weeks return could be predicted from this weeks return. Though the effect only works for portfolios, not for individual stocks, and only in the short-term - that is, daily and weekly returns - there appears to be an observable lead/lag pattern. Which means, big stocks lead little stocks, hence the name. For example, Microsoft goes up dramatically and a few days later there’s a price jump in other computer software manufacturers.

Consequently, buying second line stocks - mid caps and small caps - in a sector believed to be ready for a re-rating sometime in the near future, and then sitting on the investments patiently, can work very well. Though money can be made here purely from momentum effects, my preference is for a portfolio that’s financially sound and less likely to be buffeted aroun

vorites', or what are also known as value and glamour stocks. 'Out of favor' stocks are not stocks that are bad quality stocks, simply ones that are not attractive to the market, for whatever reason that might be. The interesting thing is, however, that over time the 'out of favor' stocks will, in general, outperform the 'favorites'. Then, when the 'out of favor' stocks become the 'favorites' due to increased buying the effect is reversed and the process is repeated in a cyclical manner, while only minor changes may take place to the stock's fundamentals. 'This occurs,' says David Dremen, who researched the effect with a portfolio of stocks over a ten year period, 'because these stocks will tend to reverse over time as investor expectations change'. Premiums paid for high growth stocks become too expensive while 'out-of-favor' stocks begin to represent greater potential gains. The effect is reminiscent of regression to the mean, a statistical effect where measurements will tend towards their average, and is in fact nothing new. Scientists have known for several hundred years that this kind of effect often occurs when human behavior is involved. What is new is that the effect has been found to occur within a particular domain of stocks.

Whether a stock is an 'out of favor' or 'favored' stock is indicated by their ratios. According to James O'Shaughnessy, whose extensive and well-researched findings were published in What Works on Wall Street, these include: price to book value (P/BV), price to cash flow (P/CF), and price to earnings (P/E). Stocks with the lowest ratios have the most potential to rise, particularly on good news surprises, and are therefore the ones, from this contrarian perspective, that should be sought after, providing they are essentially good stocks.

Momentum Strategies

Contrarian investing would seem to indicate that making money in the stockmarket, over and above the smaller but consistent returns from well-known companies like Microsoft or IBM, requires buying only 'out of favor' or value stocks. However, this is not the case. Indeed, if one were to take this to its logical conclusion no one would buy rising stocks - that were on their way to becoming glamour stocks - and profitable opportunities would be missed. In addition, value stocks take an average of five years to show a worthwhile return. Clearly that is often unacceptable and research bears out, in fact, that momentum pushes many stocks towards new heights regularly, and money can be made on these stocks considerably faster than five years. This doesn't mean that you simply buy any stocks that are rising away from their rational price due to market or behavioral influences. Such an approach would be unsystematic and likely to result in a loss. Although, as Robert Vishny points out, 'You don't necessarily make money on the best stocks in the market but on the stocks everyone thinks are going to be the best'. The rider here, of course, is that you still need to buy stocks that are good or potentially good, even though they may not be the best. Inasmuch as this is true, and you can locate these stocks, there are two momentum strategies that can be implemented.

The first strategy applies to combinations of stocks, and makes use of what is known as the big stock effect. Research on portfolio returns by Andrew Lo and Craig Mackinlay, using a mixture of small and large capitalization companies on the New York Stock Exchange, showed there was a correlation between one weeks return and the next, where around ten-percent of the price change of next weeks return could be predicted from this weeks return. Though the effect only works for portfolios, not for individual stocks, and only in the short-term - that is, daily and weekly returns - there appears to be an observable lead/lag pattern. Which means, big stocks lead little stocks, hence the name. For example, Microsoft goes up dramatically and a few days later there’s a price jump in other computer software manufacturers.

Consequently, buying second line stocks - mid caps and small caps - in a sector believed to be ready for a re-rating sometime in the near future, and then sitting on the investments patiently, can work very well. Though money can be made here purely from momentum effects, my preference is for a portfolio that’s financially sound and less likely to be buffeted arou

s kind of effect often occurs when human behavior is involved. What is new is that the effect has been found to occur within a particular domain of stocks.

Whether a stock is an 'out of favor' or 'favored' stock is indicated by their ratios. According to James O'Shaughnessy, whose extensive and well-researched findings were published in What Works on Wall Street, these include: price to book value (P/BV), price to cash flow (P/CF), and price to earnings (P/E). Stocks with the lowest ratios have the most potential to rise, particularly on good news surprises, and are therefore the ones, from this contrarian perspective, that should be sought after, providing they are essentially good stocks.

Momentum Strategies

Contrarian investing would seem to indicate that making money in the stockmarket, over and above the smaller but consistent returns from well-known companies like Microsoft or IBM, requires buying only 'out of favor' or value stocks. However, this is not the case. Indeed, if one were to take this to its logical conclusion no one would buy rising stocks - that were on their way to becoming glamour stocks - and profitable opportunities would be missed. In addition, value stocks take an average of five years to show a worthwhile return. Clearly that is often unacceptable and research bears out, in fact, that momentum pushes many stocks towards new heights regularly, and money can be made on these stocks considerably faster than five years. This doesn't mean that you simply buy any stocks that are rising away from their rational price due to market or behavioral influences. Such an approach would be unsystematic and likely to result in a loss. Although, as Robert Vishny points out, 'You don't necessarily make money on the best stocks in the market but on the stocks everyone thinks are going to be the best'. The rider here, of course, is that you still need to buy stocks that are good or potentially good, even though they may not be the best. Inasmuch as this is true, and you can locate these stocks, there are two momentum strategies that can be implemented.

The first strategy applies to combinations of stocks, and makes use of what is known as the big stock effect. Research on portfolio returns by Andrew Lo and Craig Mackinlay, using a mixture of small and large capitalization companies on the New York Stock Exchange, showed there was a correlation between one weeks return and the next, where around ten-percent of the price change of next weeks return could be predicted from this weeks return. Though the effect only works for portfolios, not for individual stocks, and only in the short-term - that is, daily and weekly returns - there appears to be an observable lead/lag pattern. Which means, big stocks lead little stocks, hence the name. For example, Microsoft goes up dramatically and a few days later there’s a price jump in other computer software manufacturers.

Consequently, buying second line stocks - mid caps and small caps - in a sector believed to be ready for a re-rating sometime in the near future, and then sitting on the investments patiently, can work very well. Though money can be made here purely from momentum effects, my preference is for a portfolio that’s financially sound and less likely to be buffeted arou

were on their way to becoming glamour stocks - and profitable opportunities would be missed. In addition, value stocks take an average of five years to show a worthwhile return. Clearly that is often unacceptable and research bears out, in fact, that momentum pushes many stocks towards new heights regularly, and money can be made on these stocks considerably faster than five years. This doesn't mean that you simply buy any stocks that are rising away from their rational price due to market or behavioral influences. Such an approach would be unsystematic and likely to result in a loss. Although, as Robert Vishny points out, 'You don't necessarily make money on the best stocks in the market but on the stocks everyone thinks are going to be the best'. The rider here, of course, is that you still need to buy stocks that are good or potentially good, even though they may not be the best. Inasmuch as this is true, and you can locate these stocks, there are two momentum strategies that can be implemented.

The first strategy applies to combinations of stocks, and makes use of what is known as the big stock effect. Research on portfolio returns by Andrew Lo and Craig Mackinlay, using a mixture of small and large capitalization companies on the New York Stock Exchange, showed there was a correlation between one weeks return and the next, where around ten-percent of the price change of next weeks return could be predicted from this weeks return. Though the effect only works for portfolios, not for individual stocks, and only in the short-term - that is, daily and weekly returns - there appears to be an observable lead/lag pattern. Which means, big stocks lead little stocks, hence the name. For example, Microsoft goes up dramatically and a few days later there’s a price jump in other computer software manufacturers.

Consequently, buying second line stocks - mid caps and small caps - in a sector believed to be ready for a re-rating sometime in the near future, and then sitting on the investments patiently, can work very well. Though money can be made here purely from momentum effects, my preference is for a portfolio that’s financially sound and less likely to be buffeted arou

>big stock effect. Research on portfolio returns by Andrew Lo and Craig Mackinlay, using a mixture of small and large capitalization companies on the New York Stock Exchange, showed there was a correlation between one weeks return and the next, where around ten-percent of the price change of next weeks return could be predicted from this weeks return. Though the effect only works for portfolios, not for individual stocks, and only in the short-term - that is, daily and weekly returns - there appears to be an observable lead/lag pattern. Which means, big stocks lead little stocks, hence the name. For example, Microsoft goes up dramatically and a few days later there’s a price jump in other computer software manufacturers.

Consequently, buying second line stocks - mid caps and small caps - in a sector believed to be ready for a re-rating sometime in the near future, and then sitting on the investments patiently, can work very well. Though money can be made here purely from momentum effects, my preference is for a portfolio that’s financially sound and less likely to be buffeted around by volatility once it moves. In other words, you are pitting your wits against market sentiment, where investor perception alone has decided these stocks are unfashionable, not against fundamental financial determinants and economic realities.

The second strategy relates to Professor Joseph Lakonishok's intriguing findings which show that high momentum stocks - as measured by their previous six months gains - outperform low momentum stocks by 8 percent to 9 percent during the following year. Hence, buying high momentum stocks can prove to be another useful method for increasing portfolio returns. Again, though, the rider is that you still need to buy stocks that are good or potentially good.

Joseph Lakonishok and his colleagues, finance professors Andre Shleifer and Robert Vishny, don't just come up with interesting academic ideas. They run LSV Asset Management, where they put into practice many of their research discoveries. Generally, they tend to avoid choosing expensive growth stocks that have been given the momentum tag. Instead, they use momentum signals - such as increased sensitivity and volatility to earnings reports or news announcements - to reveal value stocks that are just beginning the upward phase of their recovery. This is not an easy method of portfolio formation, timing and stock choice are crucial, but just like the professors, you'll find it a lot simpler if you have a specialized computer program!

Earnings Surprise Strategies

As far as momentum stocks are concerned, the trick in forming a portfolio is in using accurate measures indicating the stock is starting its rising phase. This can be somewhat harder than it first appears, even with a specialized computer program. Nevertheless, besides looking at the stock's past six months gains, earnings surprises may also be used as the deciding factor for stock selection.

One way of assessing the earnings surprise, suggested by the work of Victor Bernard and Jacob Thomas at Columbia University, is by measuring the surprise against analyst's expectations. If the surprise is not only positive but exceeds analyst's expectations there is a greater likelihood of it being a potential winning candidate for your portfolio. However, it needs to be remembered that it isn't always clear what constitutes a useful positive earnings surprise, especially when it is considered whether the earnings can be maintained or repeated in the future. One swallow doesn't make a summer! Has the company actually changed at all?

Earnings surprises can also be affected negatively in the market by analyst's evaluations and this prompts overreaction in the extreme, which again provides another useful strategy. For example, Intel dropped a hugely excessive 20 percent in three days when it had reported stronger second quarter earnings in 1995. These though came in at 4 percent under analyst's expectations, which was, behaviorally speaking, the impetus for the drop. A change-around was inevitable though as earnings continued to grow. By the spring of 1997 Intel's stock price had almost tripled. Anyone knowledgeable about the company, rather than following the investment crowd, would have made money in this situation.

A similarly striking example concerns Hewlett Packard, and it also serves to emphasize just how extreme investors' reaction to news releases can be. Exploiting this overreaction once again leads to a profitable investment strategy. In September 1992 the company announced that earnings would be below analyst's expectations. By the next day, the price had plummeted 18 percent. This reaction was totally irrational and disproportionate. In real terms for an expected reduction in earnings during the following year of a few million dollars the company's market valuation had plummeted in twenty-four hours by 3.5 billion dollars. Needless to say - if you've followed the thrust of this article so far - it won't come as a shock to know that within three months the price had fully recovered and then some.

With a profound insight into these types of behaviorally based pricing anomalies, born out by his success, and taking the view that a good investor doesn't need to be constantly trading, Warren buffet put it well when he said, 'Only look at the market to see if anyone's done something foolish that day on which you can capitalize'.

Merger Strategies

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