Researchers at the University of California Berkeley’s Haas School of Business have developed a new system designed to help investors actively avoid stock market price crashes. Based on 14 years of stock data, the system incorporates warning flags that researchers identified by studying variables associated with stock price declines. When a company receives three or more flags, it is significantly more likely that its stock price will crash, according to co-authors Richard Sloan, a professor with the Haas Accounting Group; B. Korcan Ak, a PhD candidate at Haas; Steve Rossi, an analyst at RS Investment; and Scott Tracy, a portfolio manager.
The researchers studied stock return data between 2001 and 2014 involving publicly traded companies with market capitalizations of at least US$100 million. After finding that about 70 percent of market crashes occur after earning announcements, they rated each stock to determine which companies should be assigned crash flags. They identified five key variables: unusual trading volume, high short interest, large accounting accruals, extreme valuations, and high growth expectations. Stocks in the top quintile on at least three of these variables were at higher risk for a price crash.
“We suggest that stocks with three or more flags be carefully examined before investors continue to hold them," says Sloan.
“Navigating Stock Price Crashes” is available at ssrn.com/ abstract=2585811.