As promised, today’s Two-Minute Solution is a follow-up to last week’s bargain-hunting segment: how to know when a stock is overpriced.
While there is no way to be 100% certain about a stock’s future value, there are two very simple measures that can give you a solid indication of whether it is fairly priced.
The first is incredibly simple – it’s the 52-week trading range.
When a stock is at or near its high for the year, it is usually a good reason to avoid it.
If you go back and look at the charts for most stocks just before the recent sell-off started, I’ll guarantee 99% of them were at or just below their 52-week highs.
The second method is a little more involved – it’s the 200-day moving average.
This year virtually every stock ran way above its 200-day moving average. Twenty percent above was not unusual. This is significant because stock prices will generally trend toward the 200-day average. This year that meant down!
Take a look at the 200-day chart for one of the market’s favorite income plays, Verizon (NYSE: VZ)…
As you can see, the green line, the 200-day average, is a lot closer to the price now than it was just a few weeks ago. In fact, if you go back and look at all the peaks above the 200-day line, they all resulted in a drop in price.
And this is one of the tamer charts. Until the recent sell-off, most stocks were at least 20% above the green line. So, the sell-off was no surprise to anyone who pays attention to this moving average.
This has not been a market for bargain hunters, but the sell-off is changing that.
As I said, these two indicators are not guaranteed to predict a sell-off or even weakness for a stock. But in my 30 years in the markets they have always been the best indicator of an overpriced situation.
This type of due diligence becomes more important every year because we, as retired or planning to retire investors, need to avoid big drops in the market as much as is possible. We don’t have the time we once did to allow it to correct to the upside, and we increase the yield from our stocks if we practice buying them anywhere but at the top.
Will you miss a few stocks that will continue to run up despite high 52-week prices and being significantly above the 200-day moving average?
Yes.
But the law of averages says you’ll have more winners and higher yields if you wait for prices to drop from highs and if stocks are at, near or preferably below the 200-day average.
P.S. Over the past two weeks we’ve gotten a preview of what’s going to happen to the markets as interest rates rise and the bond market crashes. My colleague Marc Lichtenfeld has been predicting for over a year now that we could see a disastrous “3-minute event” when the Fed finally takes the economy off of life support.
But he’s also figured out how investors can protect themselves – and even profit handsomely.
For more on the coming 3-minute event and how to prepare your portfolio, click here.