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Should You Dig in the Market's Doghouse?

21 June 2013 in Trading Ideas

With the broader market essentially flatlining during the past 30 days after a six-month surge of nearly 20%, the inevitable plethora of stock provocateurs has taken to the Web to wonder aloud whether this break in the action represents a mere pause before the next runup.

In other words, is now a great time to buy?

Of course, the “market” itself is the sum of its parts, and that same question is invariably applied to individual stocks each and every day. Many times this is when said stock has recently tumbled after disappointing Wall Street with a disappointing profit report or warning.

That beaten-up stocks may be offering good buying opportunities is the investment thesis behind our newest motif, Disappointing the Street.

The strategy centers on the idea that investors commonly over-punish a stock that has offered up disappointing operational results.1 When these individual selloffs don’t jibe with longer-term valuation adjustments, these stocks can recover in price.

This new motif seeks out stocks that have recently declined after a negative earnings report but are not close to recent extremes in trading ranges (which could suggest either accelerated selloffs or an already-recaptured stock price).

No stock in the motif stays in for more than 90 days.

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An element of risk is present, of course, as many stock-price breakdowns are signals of a parallel crumbling of company fundamentals. It’s worth watching closely and relying on an exit strategy because some stocks may not be able to shake negative price momentum and the perceived dip turns into a significant drop.

1W. F. M. De Bondt and R. H. Thaler, Does the Stock Market Overreact? The Journal of Finance, 40(3), (1985), 793-805.