Investing in a Hall of Mirrors Stock Market
Sometimes, it can seem like investing in the stock market is like walking through a hall of mirrors. You think you see something in front of you only to discover that nothing is there.
But when you turn around it isn’t behind you, either. All you are really seeing is yourself exactly where you are standing, reflected off of a dozen mirrors to create the illusion of space.
Consider the behavior of the S&P 500 Index over the past two months. In June, it fell steeply after the inflation report for May revealed that rapidly rising inflation has not abated.
It rallied the following week after the Federal Reserve raised the overnight bank lending rate by 75 basis points. This month, it has vacillated back and forth depending on the degree to which that day’s set of quarterly results lived up to expectations (or not).
But in the end, the index hasn’t really gone anywhere. In fact, it falls back each time it approaches technical resistance near the 4,000 level.
The index climbed above 4,000 in March 2021 on its way to an all-time high above 4,800 at the end of last year. Long story short, the index is still in bear market territory despite its recent appearance of going somewhere.
Of course, a hall of mirrors has an entrance and an exit. The easy part is walking through the entrance. The hard part is finding the exit when nothing is as it seems.
Searching for an Edge
A friend once told me that the easiest way to get through a hall of mirrors is to go to one edge of the room and feel your way along it. Eventually, you have to arrive at the far end of the room where the exit can be found.
I’ve been thinking about that advice lately as it pertains to the stock market. I have been searching for an edge that will guide me to a successful exit.
To that end, I have been back-testing a variety of fundamental and technical metrics. My objective is to identify a set of criteria that will indicate which stocks have become oversold and are likely to rebound.
In the near term, my goal is to outperform the index. However, that does not necessarily mean posting a gain. When the index is down, I expect my stocks to be down by a lesser amount.
Conversely, when the index is up, I want my stocks to perform even better. I have no control over the direction of the stock market, but I can control how my portfolio performs compared to it.
To do that, I focus on three fundamental metrics:
- Price-to-earnings growth (PEG) ratio
- Return on equity (ROE)
- Earnings per share (EPS) growth rate
In addition, there are three technical indicators that I use:
- Relative strength indicator (RSI)
- Directional movement indicator (DMI)
- Stochastics Oscillator (SO)
Among the thousands of stocks that trade on the major U.S. exchanges, only 85 met all of my criteria last week. They represent the edge of the stock market that I am looking for to get through this hall of mirrors.
Deere in the Headlights
One of those stocks is Deere & Co. (NYSE: DE). Three months ago, DE reached an all-time share price above $446. Three weeks ago, it bottomed out below $290 before finding a floor.
That’s when my system flagged DE as being oversold. Since then, it has rallied above $310 and appears to be in the early stages of a recovery.
You don’t have to pay more than $300 a share to participate in Deere’s future stock market performance. Instead, you can buy a call option on Deere that will cost you considerably less (call options increase in value when the price of the underlying security goes up).
Last week while DE was trading near $312, the call option that expires on December 16 at the $310 strike price could be bought for $37.
For that trade to be profitable, DE must rise above $347 by the time this option expires. That equates to share price appreciation of roughly 11% in a little under five months.
That may seem optimistic but bear in mind that DE was trading above that price less than two months ago. If Deere surprises Wall Street with better than expected news when it releases its next set of quarterly results in August then it could get back above that level just as quickly.
Of course, a lot of things could go wrong to undermine this trade. Inflation could keep rising faster than expected. Another resurgence of COVID-19 could once again gum up global supply chains. None of us have any control over any of that.
But what we do have control over is how we manage risk in our investment portfolios. And right now, Deere appears to be one way to navigate the hall of mirrors
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