Low-Priced Stocks Pulling Back in Long-Term Uptrends

With many major stock market indexes trading near new all-time highs, we could be in the early stages of a new bull market. Or, we could also be near the end of a bull market and the beginning of a bear market. High prices have a way of increasing optimism in some investors and raising fear levels in others. Overall, there seems to be a stronger argument to be made for the bullish case and the bull market appears likely to continue for at least several months. Among the factors pointing to higher highs are a strong technical picture in the major market averages and increasingly bullish sentiment that the next year will bring increased government spending on infrastructure and decreased government regulation. A decrease in regulation could lower compliance costs and boost the profits of both large and small businesses.

In major bull markets of the past, many investors have profited from buying the dips. This was a popular strategy in the 1980s and 1990s as the bull market carried stocks to new highs year after year.

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Buying the dips sounds appealing because it involves buying shares after prices drop in expectation of a rally. In a bull market, rallies push prices to successive new highs. Because the strategy depends on a long-term up trend, buying the dips has lost favor among investors since bear markets began to change investor psychology beginning in 2000. Buying the dips in a bear market simply compounds losses.

Although we never know for sure whether a dip is a pullback in an up trend or the beginning of a bull market, we can quantify the strategy to reduce the risks. Rather than blindly buying stocks in down trends, we can limit trades to stocks that are above their 200-day moving average (MA). By definition, a stock trading above its 200-day MA is in a long-term up trend. The dip, or the short-term down trend, can be quantified with the 20-day MA. When a stock is below the 20-day MA the price is in a short-term down trend by definition. These two criteria quantify the dip in an up trend.

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Next, we need an indicator to limit risk because there is a risk of loss on any trade. To do this, we limit trades to stocks that are trading near their 52-week highs. Many investors avoid stocks trading near new 52-week highs but research demonstrates these are the stocks most likely to outperform the market over the next six to twelve months. These are stocks with high momentum and momentum stocks tend to be the biggest winners, especially in a bull market.

This week, we found five stocks that passed this test.

Lattice Semiconductor Corporation (Nasdaq: LSCC) provides smart connectivity solutions powered by low power FPGA, video ASSP, 60 GHz millimeter wave, and IP products to the consumer, communications, industrial, computing, and automotive markets worldwide. LSCC also offers mmWave devices, such as gigabit connectors, gigabit indoor devices and modules, and gigabit outdoor products that allow customers to wirelessly transfer data and ultra high-definition video content. LSCC sells its products directly to end customers through a network of independent manufacturers’ representatives, as well as indirectly through a network of independent sell-in and sell-through distributors. Management notes the company is “the global leader in smart connectivity solutions, providing market leading intellectual property and low-power, small form-factor devices that enable more than 8,000 global customers to quickly deliver innovative and differentiated cost and power efficient products.”

LSCC is expected to report earnings per share (EPS) of $0.48 next year and analysts expect EPS growth to average 20% a year after that. The PEG ratio provides a model that can be used to find the expected fair value of a growth stock. This model assumes the stock is trading at fair value when the price-to-earnings (P/E) ratio is equal to the EPS growth rate. With a P/E ratio of 20, the company’s expected growth rate, LSCC would trade at $9.60, more than 35% above the stock’s current price.

Owens-Illinois, Inc. (NYSE: OI) manufactures and sells glass containers to food and beverage manufacturers primarily in Europe, North America, Latin America, and the Asia Pacific. OI produces glass containers for alcoholic beverages, including beer, flavored malt beverages, spirits, and wine. OI is also involved in the production of glass packaging for various food items, soft drinks, teas, juices, and pharmaceuticals. This is a boring but stable business and after a period of rapid growth, OI is transitioning to slow growth. From 2010 through the end of 2015, EPS growth averaged more than 38% a year. In the next five years, analysts expect growth to average about 10% a year. EPS are expected to be $2.30 in 2016 and $2.52 in 2017. The stock is trading with a P/E ratio of about 7.8 based on expected earnings. On average, companies in the containers and packaging industry have traded at 17.8 times earnings over the past seven years. At the average P/E ratio, the stock could trade at more than $40 in the long run. The chart provides a shorter-term price target of $25.

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CYS Investments, Inc. (NYSE:CYS) is a specialty finance company that invests in residential mortgage pass-through securities in the United States. CYS also purchases residential mortgage-backed securities (RMBS) that are issued and the principal and interest of which are guaranteed by a federally chartered corporation (Agency RMBS); debt securities issued by the United States Department of Treasury; and collateralized mortgage obligations issued by a government agency or government-sponsored entity that are collateralized by Agency RMBS.

This is a potential Trump trade. The secondary market for mortgages has been largely under government control since the financial crisis. Some of Trump’s biggest backers are hedge fund managers with an interest in privatizing that market. Economists from both parties see benefits to the proposed privatization and adoption of that policy would be likely to help CYS. Even without privatization, the stock appears to be undervalued. Analysts expect EPS of $0.99 next year and $0.86 in 2018. At just 12 times 2018 estimated earnings, the stock would be worth more than $10 a share. A more likely multiple of 15 provides a price target of $12.90. Based on expectations, the stock is at least 20% undervalued.

ING Groep N.V. (NYSE: ING) is a global financial institution with more than 52,000 employees who offer retail and wholesale banking services to customers in over 40 countries. ING operates through Retail Netherlands, Retail Belgium, Retail Germany, Retail Other, and Wholesale Banking segments. The company accepts various deposits, such as current and savings accounts; and offers business lending, consumer lending, and lease products. It also provides mortgages; corporate, structured, and real estate financing services; financial markets products; and cash management, transaction, and trade finance services, as well as working capital solutions.

Analysts expect EPS of $1.22 this year and $1.24 next year. Over the past five years, the stock has traded at an average P/E ratio of 15.6. This provides a price target of $19, a gain of more than 40%. The dividend yield of 5.5% is well covered by earnings and cash flow and seems secure. The large payout provides support to the stock which should limit downside risk and adds to the potential total return of the trade.

These four stocks are candidates for a “buy the dip” strategy. When selected, they were below their 20-day MA but above their 200-day MA. The 50-day MA could be used as a stop-loss to manage the risk of these trades. That could also serve as a trailing stop to help identify when you should take profits. Overall, this represents a mechanical strategy for value stocks that could deliver big gains in a bull market.