Pattern recognition is usually associated with technical analysis. Investors study charts, trying to identify patterns that have been seen in the past. They project the pattern into the future and prepare to count their winnings.
Unfortunately, pattern recognition is not that simple.
While price patterns are useful, they are prone to misinterpretation. Many investors unconsciously project their biases onto the chart. Once they read about the head-and-shoulders pattern, they suddenly start "spotting" it on hundreds of charts.
When we look for price patterns, we also confirm the chart with other technical indicators and fundamentals. And we consider whether the pattern fits the basic outline of a top, a bottom or a consolidation. The specific name of the pattern isn't important since all patterns find price objectives with simple measuring rules.
When we see a bullish pattern, we can use relative strength (RS) to confirm it. If it really is bullish, RS should be rising.
For fundamentals, we usually prefer to look at the PEG ratio to confirm our technical-based opinion. The PEG ratio compares the price-to-earnings (P/E) ratio to the earnings per share (EPS) growth rate. Stocks with a PEG ratio under 1 are considered to be undervalued.
These three factors affirmed Green Mountain Coffee Roasters (GMCR) was a "buy" in August when Amber first recommended the stock. The stock was beaten down on concerns that Starbucks (SBUX) would compete directly with GMCR. In the end, SBUX actually expanded its partnership with GMCR, and that trade delivered a 320% gain in five months.
In looking for those same characteristics today, we found Meritage Homes (MTH). Just like GMCR, recent news stories raise some concerns about the company's future. Homebuilders are facing higher costs, and that could squeeze profits. Meritage builds in some of the hardest hit housing markets like Phoenix and California.
Despite the news, MTH is actually a turnaround stock that could have a bright future.
After years of falling earnings, analysts expect the company to report average annual EPS growth of almost 70% over the next five years. Based on estimated earnings for 2013, MTH is trading with a price-to-earnings (P/E) ratio of 22. MTH has a PEG ratio of 0.31, making the stock potentially 70% undervalued.
Turning to the chart, we see rising RS and a pattern that offers a higher short-term price objective.
The weekly chart on the left shows the high RS. The price target near $63 can be seen on the daily chart.
Risk can be limited by placing a stop at $43.50 near the midpoint of the pattern. To capture a potentially larger gain, if MTH reaches the target price, the 10-week moving average could be used as a trailing stop.
Recommended Trade Setup:
-- Buy MTH below $53.50
-- Set stop-loss at $43.50
-- Set initial price target at $63 for a potential 18% gain in 6-12 months
To further reduce the risk, call options can be used. Call options give the buyer the right to buy 100 shares of stock at a predetermined price within a predetermined amount of time. Options traders generally have the chance for a larger reward with a defined amount of risk.
For MTH, a call option with an exercise price of $55 expiring in December offers a potential gain of 70%. If MTH reaches the target of $63, these options would be worth at least $8. They are trading at about $4.70 a share, offering a potential gain of $3.30. The maximum loss is the amount paid for the options, $4.70 in this case, although the loss would be smaller if MTH is trading above $55 when the call expires in December. The loss might also be reduced with a stop-loss.
Recommended Trade Setup:
-- Buy MTH Dec 55 Calls for $5 or less
-- Set stop-loss at $2.50
-- Set initial price target at $8 for a potential 60% gain in 7 months
We believe that it is important to look at technicals and fundamentals to find the biggest potential winners in the stock market. MTH is a buy using these indicators.