384

METHODOLOGICAL,

PSYCHOLOGICAL,

PHILOSOPHICAL,

STATISTICAL FOUNDATIONS

.604 versus .046 in stocks. These results support the notion that futures trend followers are earning a risk premium that is not available to trend followers in stocks. See Figure 7.15.

Liquidity Premium and the Gains to Counter Trend Trading in Stocks

The stock market offers risk-taking stock traders a different form of compensation. They can earn a premium for providing liquidityto highly motivated sellers. In other words, there are systematic price movements in stocks that can be exploited with countertrend strategies that buy stocks that have been very weak over the recent past. Owners of stock with an urgent need to liquidate their holdings need buyers. This suggests that the market should offer compensation to traders who are willing to meet unmet needs for liquidity. Evidence presented by Michael Cooper shows that buyers of oversold stocks can earn above-average short-term returns.!" His study shows that stocks that have displayed negative price momentum on declining trading volume earn excess returns. In other words, the pattern identifies stocks with distressed sellers in search of buyers. The excess returns appear to be a liquidity premium. Cooper's study showed that stocks that have declined sharply over the prior two weeks on declining volume display a systematic tendency to rise over the following week. The declining volume aspect of this pattern is plausible because it can be interpreted to mean that there are insufficient buyers to meet the acute needs of the sellers. To guard against the possibility of data mining, Cooper used a walk-forward out-of-sample simulation to form portfolios of long and short positions over the period 1978 to 1993. The long/short portfolios, created from 300 large capitalization stocks, earned an annualized return of 44.95 percent versus a benchmark buy-and-hold return of 17.91

Sharpe Ratio

0.7 0.6 0.5 0.4 0.3 0.2 0.1 0

,.._.

_t=(J_ Futures Stocks to trend-following futures versus stocks.

FIGURE 7.15

Risk-adjusted

returns