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Monday, September 3, 2012 - 06:00
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Monday, September 3, 2012 - 06:00
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Monday, September 3, 2012 - 06:00

Second Chance to Buy a Bottom for a Potential 340% Gain

Monday, September 3, 2012 - 6:00am

Europe is in the news again, although it seems like the continent's financial turmoil is always in the news. European Central Bank (ECB) President Mario Draghi was quoted in The Wall Street Journal as saying, "It should be understood that fulfilling our mandate sometimes requires us to go beyond standard monetary policy tools. When markets are fragmented or influenced by irrational fears, our monetary policy signals do not reach citizens evenly across the euro area."

In previous comments, Draghi, the European equivalent of Fed Chairman Ben Bernanke, has assured investors that he will do all he can to save the euro. Now, he worries that the markets have become irrationally fearful, and I think he may have a point.

We can measure the level of fear in the stock market with the price-to-earnings (P/E) ratio of a stock market index. When the P/E ratio is high, there is very little fear in the market, and when the P/E ratio is low, there is widespread fear. This indicator tells us that there is fear in Europe. According to the Pragmatic Capitalism blog, the Shiller P/E for "Europe at 11.4x is at its cheapest level since the 1980s apart from the immediate post Lehman bankruptcy period."

Shiller P/Es use earnings data over a 10-year period to smooth the impact of the shorter-term business cycle. Cambria Research has studied Shiller P/E ratios in detail, using data from 32 countries from 1980 through 2011, and found that the ratio falls under 15 about 30% of the time. Buying all country indexes when the Shiller P/E is between 10 and 15 would have resulted in an average gain of 22.8% over the next year.

With Europe's P/E ratio at 11.4, it could be time to buy to take advantage of irrational fear. With the P/E ratio near the level it was at when the 2009 bear market ended, buying now is like getting a second chance to buy that bottom.

Vanguard MSCI Europe ETF (NYSE: VGK) offers a way to trade this idea. VGK looks like it may be completing a double-bottom pattern on the chart. The buy signal from this pattern would be given at about $47.40, approximately 6% above the recent price of VGK. With a break above that price, VGK has a price target of $56, which is 18% above the buy price.

By waiting for price to move higher and confirm that the double-bottom has formed, traders minimize the risk that the market stalls out at resistance near the top of the pattern. Rather than waiting for a buy signal to manage our risk on the trade, we could use options and risk a small amount of money for a potentially large gain.

Options have an expiration date, so it is important to consider the time frame of the expected price move when choosing an option. The trigger for this trade was comments from the head of the ECB, and central bank actions require months or years before we can see results. That means we should look at options that expire as far in the future as possible.

March 2013 call options are available on VGK. The $45 call is trading at about $2.50 at the time of this writing, which means we would have a cost basis of $47.50 if we exercised the option, about the same entry price dictated by the pattern. If VGK rises above the cost basis before options expiration on March 15, 2013, then the trade is profitable. At the price target of $56 for VGK, the option would be worth $11, a 340% profit.

This trade risks a small amount on the idea that irrational fears have taken hold in Europe. Judging from the headlines, it is very possible that traders are overly pessimistic about the fate of Europe given the ECB's pledge to do all they can. Traders in the United States have always said, "Don't fight the Fed." In a global market, we probably don't want to fight the ECB either.

Action to Tale --> Buy VGK March 2013 45 calls at $2.50 or less and set initial stop-loss at $1.25 with an initial price target at $11.

Amber Hestla does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.