Over the past couple of weeks, the Dow has taken a nosedive into sub-11,000 territory and is currently trying to fight its way back. However, this is still way off the highs it set just last October when it hit the 14,000 mark. Of course, the economic problems will likely keep the market from retouching those lofty levels, but it is safe to say there is probably more upside than downside at this stage of the game.
This is how I try to look at individual stocks. Upside vs. downside potential. I have had my fair share of bad buys over the years listening to the so called "experts" on CNBC. So I set out to educate myself on better understanding optimal times to buy stocks. Obviously, no one is able to predict which way a stock is headed, so the name of the game for me is to figure out the best time to enter that will maximize the upside/downside ratio. There are many sites on the Web to learn about the various candlestick patterns representing bullish and bearish signals which can be used to trigger appropriate buy/sell signals. I often evaluate these charts, but for me, I tend to keep things simple with 2 basic metrics:
RSI Indicator
This is an indicator of how overbought or oversold a particular stock is. You can overlay the RSI onto popular charts like those on Yahoo! Finance. You will notice that low RSIs generally coincide with down periods for the stock. I look for an RSI to reach about 30 before I buy. This gives me the confidence to know that a stock is already oversold and thus, its downside is probably limited.
PEG Ratio
This refers to the ratio of the PE to a company's earnings growth rate. The general consensus is that a PEG of less than 1 represents a company that is undervalued and a ratio of over 2 is considered to be overvalued. Usually, you will see the ratio falling somewhere between 1 and 2. It is good to look for a buying opportunity when the PEG starts going below 1.2 or 1.3. Again, the name of the game is to find an entry point that may limit big downside. As the PEG gets close to 1, the potential downside should decrease. An important thing to keep in mind is that since the ratio is using earnings estimates to calculate its value, you should keep track of any earnings adjustments made by companies during their earnings releases. This will shift both the PE and the earnings growth rate.
Of course, I am not advocating that these two things should be used to screen for stocks to buy. You should still understand the stock's sector and have a rationale for why you believe the stock will outperform its peers going forward. These metrics are solely used to figure out a good time to buy a stock which you've decided should be part of your portfolio.
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