Trade Update July 16, 2012 at 11:10 am: Since buying the CAT Aug 85/75 put spread for 2.25 on May 24th, the stock has moved almost 15% lower as Chinese weakness has become more widely acknowledged. In fact, the Shanghai index closed at 6 month lows today, despite 2 interest rate cuts in the last month and speculation of further stimulus measures to come. The Chinese Yuan is also at 6 month lows vs. the dollar. I expect more weakness out of China, but given that I have initiated a batch of new short positions in the past 2 weeks, I want to take some exposure off the table here, especially since I think CAT is ahead of the broader market in pricing in future weakness. So I am selling half of the put spread for slightly more than a double, and will let the other half ride.
Action: CAT (80.75), sold half of the Aug 85/75 put spread at 4.60
Original Trade May 24th, 2012:
While I read endless reports about the next remarks from insert European politician here, few people are mentioning the steady drip of reports of Chinese weakness. China is the 2nd largest economy in the world, and the largest contributor to global GDP growth over the last 5 years. Probably worth paying attention.
For example, the Chinese Yuan, CNY, hit its lowest level against the dollar in 2012 last night, but most investors likely were not aware. Here is the chart (higher exchange rate means stronger dollar, lower yuan):
Granted, this is still a very small drop in the Yuan, but this is the first year in the last 10 years that the Yuan has actually been positive on the year in May. FTAlphaville’s article last week speculated that it might be investors looking to move investments out of China for the first time, but whatever the case, that movement in the exchange rate is bizarre.
A second warning sign of weakening Chinese demand has been the weakness in industrial commodities like copper. FTAlphaville (again) has speculated that many Chinese borrowers have used commodities as collateral for extensive leverage (similar to the U.S. subprime crisis in which houses were the collateral backing too many loans), but whatever the full story, the chart of Copper (red line) and FXI (blue) against SPY (green) shows how closely Chinese stocks move with copper:
When I couple that Yuan drop with this chart of Copper and FXI vs. SPY over the last year, it does not show a favorable picture of Chinese demand.
Faced with such obvious weakness in the global commodity complex, Caterpillar is one of the large-cap names most exposed. It recently noted a recent slowing of Brazilian and Chinese growth (which helped push along its steep 20% descent from highs this year), which is particularly problematic for CAT given their recent acquisition of Bucyrus, a mining equipment firm. CAT has made a big bet on industrial commodity prices, and with them, Chinese growth, and that bet seems to be, in hindsight, badly misplaced.
TRADE: CAT ($91.25) Buy August 85/75 Put Spread for 2.25
- Buy 1 August 85 Put for 3.95
- Sell 1 August 75 Put at 1.70
Break-Even on August Expiration:
- Profits btwn 82.75 and 75 make up to 7.75, Max Gain 7.75 with stock 75 or lower
- Losses of up to 2.25 btwn 82.5 and 85, with max loss of 2.25 with stock 85 or higher
TRADE RATIONALE:
I’ve debated this entry given the stock’s oversold condition, but I’m more nervous about missing this trade than seeing CAT go a few bucks higher after my entry, mainly because I’m going to use an Aug put spread so that I capture July earnings, when CAT should be forced to admit the extent of Chinese weakness.