HD hit a new all-time high today, rising just about 10% from the intraday low last week. The stock’s rapid snapback rally is especially interesting for a $127 billion market cap stock that normally exhibits low volatility.
Considering the very weak earnings result from Lumber Liquidators this morning (LL down 10%), HD’s strength today is a vote of confidence in the company’s ability to continue to retain market share in the home improvement segment.
HD has been a large cap leader throughout the bull market, as we discussed in a NTT post nearly 2 weeks ago (full post below):
While Home Depot has certainly done a better job managing its business than other companies in the sector, the sector weakness indicates that the backdrop for housing-related spending is far from healthy. Also here is another example of a company that is very effectively managing their balance sheet, and thus their earnings. Last December the company did an accelerated share buyback to the tune of $3 billion and then in early June the company issued $2 billion in debt to buy back more stock. The result of solid execution and lowered share count has helped the company achieve fantastic earnings growth near 20% year over year, despite sales growth in the mid single digits. This is a trend that we don’t think can continue, meaning lever up to buyback shares in a tepid sales growth environment.
As we’ve seen in the past week with IBM, KO, and MCD, simply buying back stock without significant sales growth or business expansion is not a recipe for long-term success. Home Depot has done a better job that those names in managing its overall business, but the stock’s valuation has been juiced by the buybacks, and we think the recent strength should be faded:
TRADE – HD ($94.74) Bought the Feb 95/85 Put Spread for $3.05
-Bought 1 Feb 95 Put for $4.44
-Sold 1 Feb 85 Put at $1.39
Break-Even on Feb Expiration:
Profits: btwn 85 and 91.95 make up to 6.95, max gain of 6.95 at 85 or lower
Losses: btwn 91.95 and 95 lose up to 3.05, with max loss of 3.05 at 95 or higher
Rationale: We view the likelihood of a 5-10% move lower in HD as greater than a 5-10% move higher over the next 4 months. HD traded as low as $86.50 just last week, and we see the risk of a similar swoon at some point in the next 4 months as underpriced by the options market at the moment. Given HD’s breakout above $83 in August, we don’t anticipate much more downside below the $85 level, which is why we chose the 95/85 put spread as our structure.
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Name That Trade – $HD: DIY Earnings Growth
Thirty day at the money implied volatility (price of options) in the S&P 500 index has neared its 2 year high in the last week, accompanying the increase in realized volatility (how much the underlying is moving) that we have seen. Here is 30 day implied volatility vs. 10 day realized volatility in the index in the past 2 years:
[caption id="attachment_46626" align="alignnone" width="600"]
SPY 30 day implied volatility (blue) vs. 10 day realized volatility (white), courtesy of Bloomberg[/caption]
The rapid increase in options pricing has generally been an opportunity to fade the move over the past 2 years, so many traders are naturally looking at buying stocks and selling options in the past 2 days.
We are less comfortable with that strategy given the serious macro headwinds and the continued negative breadth. After yesterday’s selloff, the percentage of NYSE stocks trading above their 200 day moving average is now at a 2 year low:
[caption id="attachment_46627" align="alignnone" width="600"]
Percentage of NYSE stocks above their 200 day ma, courtesy of Bloomberg[/caption]
This selloff doesn’t exactly look like the prior selloffs of the past 2 years in terms of internals, so our hunch is that the volatility profile might not follow the usual script either.
However, with VIX futures already in the high teens, we don’t see a favorable trade in the VIX that offers good risk/reward. Instead, we’ve been focusing on some of the large cap winners where implied volatility is still low and investors are using them as safe havens as they sell higher beta names. Our trade idea on DIS last month was a good example of that.
After screening through the large cap names, HD is the one name that stood out to me as a stock that is near its all-time highs, and its implied volatility is only near the midpoint of its 2 year range:
[caption id="attachment_46630" align="alignnone" width="600"]
HD 30 day implied vol, courtesy of Bloomberg[/caption]
Most other stocks currently sport implied volatility levels near 2 year highs. Moreover, HD is hardly a consumer staple or utility stock, which have acted defensively in the past week. HD is a hideout stock for fund managers, and if broader market selling continues over the next month, HD is likely going to see some downside volatility as well.
HD actually made a new all-time high intraday yesterday, and has held up exceptionally well since its breakout on a strong earnings report in August:
[caption id="attachment_46635" align="alignnone" width="600"]
HD daily chart, courtesy of Bloomberg[/caption]
However, the stock is more than 10% above the breakout level, so there is plenty of room for HD to fall if selling picks up.
In the meantime, the housing-related stocks as a whole have actually been getting hit hard, and XHB made a new 52 week low today:
[caption id="attachment_46636" align="alignnone" width="600"]
XHB daily chart, courtesy of Bloomberg[/caption]
While Home Depot has certainly done a better job managing its business than other companies in the sector, the sector weakness indicates that the backdrop for housing-related spending is far from healthy. Also here is another example of a company that is very effectively managing their balance sheet, and thus their earnings. Last December the company did an accelerated share buyback to the tune of $3 billion and then in early June the company issued $2 billion in debt to buy back more stock. The result of solid execution and lowered share count has helped the company achieve fantastic earnings growth near 20% year over year, despite sales growth in the mid single digits. This is a trend that we don’t think can continue, meaning lever up to buyback shares in a tepid sales growth environment.
The trade that we considered was the Feb 90/80 put spread for around $2.00 in HD (with stock around $$93.40). That trade has more than 4 months to expiration, takes advantage of the reasonably low implied volatility, and would be a nice winner on a retrace back to the $85 level at some point in the next few months. We already have a number of bearish positions of this nature on at the moment, so we are going to put this one on the watch list for a time when we see some market strength.