Why I'm Buying These Hated Stocks

Jared Levy's picture

Monday, January 18, 2016 - 5:00pm

by Jared Levy

Panic can lead humans to make very poor decisions. In the heat of the moment, we tend to revert to our most basic fight-or-flight instincts.

For instance, in a market sell-off, when stocks keep going further and further down, many investors just want the pain to stop... so they sell, locking in a loss but ending the burden of the unknown.

Unfortunately, that's often the worst decision they can make. Stocks usually recover from market panics when investors finally come to their senses. It doesn't always happen exactly like this, but the point is that panic can send stocks into oversold territory without solid fundamental reasoning.

Small-cap stocks are extremely sensitive to market panics and tend to be scapegoats for market stress.

That's what we're currently seeing in the Russell 2000. The index has already fallen 10% this year, putting it more than 20% below its 52-week high and in extremely oversold territory.

While its problems may not be over, I think we'll get a snapback rally over the next few months that could deliver double-digit profits to those who have the courage to take a position now. 

There are three strong indicators supporting my thesis.

1. Made In America

One reason I'm confident in the Russell 2000 is its domestic focus and the relative strength of the U.S. economy. Unlike the blue-chip companies that make up the S&P 500, which tend to generate at least half of their revenue from foreign sources, only about 19% of the Russell's revenue comes from overseas.

That's a good thing. The crazy rout that's taken hold of U.S. markets actually has little to do with our country. It's the Chinese stock market -- which most Americans have no stake in -- that's causing the ruckus.

Despite U.S. investors' dramatic reaction to China's market woes, things in the United States are holding up just fine, especially when compared to many of our trade partners.

For example, the December jobs report showed the addition of 292,000 jobs -- 81,000 more than the consensus estimate. Meanwhile, the economy added 2.65 million jobs in 2015 -- the second best year since 1999.

While our economy could admittedly be stronger in other areas, it's at the very least stable and growing. And companies in the Russell 2000 are expected to deliver year-over-year earnings growth of 2.6% in Q4 on nearly 3% revenue growth. That's not earth-shattering, but it's also not terrible enough to warrant the recent panic. And it's much better than the companies of the S&P 500, which are expected to post a 5.3% decline in profits on a 3.3% drop in revenue.

Based on its much larger exposure to foreign markets, the S&P 500 should actually be getting hit harder. But for whatever reason, the brunt of the panic is focused on the Russell.

And let me be clear, the Russell 2000 isn't comprised of tiny, unreliable companies, even though the market seems to be treating it as such. The companies that make up this index are roughly valued between $200 million and $4 billion, with an average market cap of $1.89 billion, and they all trade on a major U.S. exchange. 

2. Valuation Signals 'Buy'

When any index is getting battered, I look at its charts and price-to-earnings (P/E) multiples to see just how bad things could get. The Russell 2000 is trading at a two-year low in both its trailing (green) and forward (brown) multiples.

A higher-than-average forward P/E would signal future earnings weakness and potential trouble to come, but that's not what we're seeing.

The recent drop in the forward P/E looks very similar to ones we saw in December 2014 and June 2015. After valuations plummeted, investors rushed into the index. At those times, the U.S. dollar was rising, the domestic economy was strong and risks in China were mounting. Sound familiar?

If the Russell were to trade back at its average forward multiple of 25.67, it would be valued around 1,239, based on analysts' current earnings estimates. This is roughly 20% higher than current prices. 

3. Technicals Tout A Turnaround

Looking at the chart of the iShares Russell 2000 (NYSE: IWM), the ETF that tracks the small-cap index, there have been eight times where it has violated its Bollinger Bands following a 5% to 10% correction over the past two years. 

In each of the previous instances when the ETF dropped 5% to 10% from its peak, it recovered its losses within three months, with most rebounds happening much quicker. 

IWM

Based on past observations, the sharper (faster) and deeper the sell-off, the quicker the recovery. That spells opportunity, as the recent panic has caused the most dramatic drop IWM has seen in two years.

I'm not calling for a return to new highs, but I do expect a recovery to its previous lows around $111, about 9% above current prices, over the next few months. That's not exactly an eye-popping return, and I understand that despite Thursday's rally many of you are still in panic mode. So I want to share an alternate route with you.

Back in August, I predicted IWM was going to fall based on a confluence of technical and fundamental factors. I set my target a conservative 3% below where the fund was trading at the time and advised traders to buy a put option to leverage the move. 

The puts cost us $785 per contract, but I recommended a stop-loss at $300, meaning we were risking no more than $485. 

IWM started falling immediately after we entered our put position, and we got taken out at our target just four days later for a return of 34%. That worked out to an annualized return of more than 3,000%!

Since I'm bullish this time around, we are buying a simple call option that will deliver a 63% profit if IWM rallies to $111 by mid-April. And the best part is we risk just $500 per contract.

Now, I can't tell you the specifics of the trade here, since that wouldn't be fair to my Profit Amplifier subscribers who just got my alert this week. But I will tell you there is still time to get in. 

I think most investors are going to be surprised when small caps make a comeback. And those who get positioned now will reap the rewards. If you're interested in getting the IWM trade details while there's still time to get in, and learning more about how I select my option trades, go here.

This article was originally published on ProfitableTrading.com: Why I'm Buying These Hated Stocks

Jared Levy 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.