The Indicator That Could Keep You From Getting Fooled by 'Cheap' Stocks

Fundamental analysts generally focus on a company's financial statement. They use tools like the price-to-earnings (P/E) ratio and dividend yields to find value. Many investors like to buy when these indicators are low. There are studies showing that this approach works in the long term. However, most of those studies could never be implemented by individual investors.

When studying P/E ratios or other fundamental measures of value, researchers generally divide the market into 10 groups. Each stock is assigned to one of those groups. Researchers then measure the performance of the group and usually find that the group with the lowest P/E ratio or the lowest dividend yield provides the best returns.

There are at least 6,500 stocks being traded on U.S. exchanges right now. To duplicate a value strategy that is likely to outperform the market, you might need to buy 650 stocks. You could just select the stocks with the lowest ratios in the S&P 500 and perhaps buy only 100 stocks. As you can see, the problem an individual investor faces is that their account isn't large enough to buy so many stocks.

To help narrow the list, individual investors can apply a tool of technical analysis to fundamental data that will help them identify the stocks that deliver the best value.

Bollinger Bands are used in technical analysis to spot when prices are too high or too low. This indicator adds and subtracts two standard deviations from a moving average of the price. It can easily be added to any chart using many popular websites.

Bands are designed to include about 95% of the price action so when prices move above or below the Bands, it is unusual and a signal that something significant is happening in the market. When prices break above the upper Band, they often reverse lower or at least consolidate the recent gains. And prices crossing the lower Band often signals a low-risk buying point.

Bollinger Bands can actually be applied to any indicator, including P/E ratios and dividend yields. When P/E ratios are very high and above the upper Band, the stock price is overvalued and could be ready to fall. Stocks with P/E ratios below the lower Band could be the best value stocks in the market.

For example, Goldman Sachs (NYSE: GS) has a P/E ratio below 12, a level generally associated with an undervalued stock. However, the P/E ratio is actually at the upper Bollinger Band and is high relative to its normal value. Rather than being undervalued, GS is more likely to be overvalued when the P/E ratio is placed in context.

Apple (NASDAQ: AAPL) is also relatively overvalued despite an unusually low P/E ratio around 10.

On the other hand, Verizon (NYSE: VZ) with a P/E ratio of about 130 could be a buy with a P/E ratio near the lower Bollinger Band.

Value investing is appealing to many individual investors because it seems logical. The idea is to buy stocks with low P/E ratios and avoid those with high P/E ratios. Unfortunately, the absolute level of a P/E ratio tells us very little about whether an individual stock is a value stock or not. Adding Bollinger Bands to the P/E ratio could help investors find unusually cheap stocks and could help them to avoid stocks that are overvalued on a relative basis.

When selecting value stocks, consider the P/E ratio within context and decide whether it is high or low based on the history of the P/E ratio for the stock you are looking at.

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