Name That Trade: $CAT Scratch Fever

by Dan May 29, 2015 2:15 pm • Commentary

While the weakness in the Transports has caught a lot of attention of late, the relentless selling in some Industrial stocks may be more important for the direction of the broad market in the near future.  The selling in airline stocks was bound to come on the slightest bit of bad news as they were very crowded trades, but continued selling in unloved stocks like Joy Global (JOY) and Navistar (NAV), both approaching 52 week lows, and Cummins (CMI) nearing 2015 lows is notable as investors seem to have little appetite for economically cyclical sectors at the moment, despite the S&P 500 just 1% from the all time highs.

The three best performing sectors in the S&P 500 year to date are Healthcare, Consumer Staples and Technology, all either defensive, returning cash hand over fist to investors or struck with M&A fever.  Industrial stocks are flat on the year vs the S&P 500 which is up 2.7%.

Earlier this week (read here) we placed a trade that faded the recent breakout in Deere (DE). The trade has less do with current fundamentals, which seem less bad than competitor Caterpillar (CAT), and largely focused on the probability of continued consolidation as opposed to a breakout to new 5 year highs.

On the flip-side, CAT’s fundamentals remain challenged with greater exposure outside of North America than DE (55% vs 35%), and far greater exposure to emerging markets.  To top it off the technical set up for CAT vs DE couldn’t be more stark.  While DE is at 52 week highs, and 5% from the five year highs, CAT is in a massive downtrend since making new multi-year highs in mid 2014 and down almost 25% from the highs:

CAT since Jan 2014 from Bloomberg
CAT since Jan 2014 from Bloomberg

On a longer term basis, CAT is now approaching a technical danger zone between $85 and $80, and I suspect further weak data from emerging markets, six years into the global recovery could cause a meaningful break below $80:

CAT 3 year chart from Bloomberg
CAT 3 year chart from Bloomberg

The late 2013, early 2014 strength in CAT can likely be explained away from the company’s aggressive share buyback activity, as early last  year they completed a $1.7 billion accelerated buyback and the last summer authorized another ASR that time to the tune of $2.5 billion. Going forward in a potentially higher interest rate environment will company’s be less inclined to issue debt to buyback their own stock??

Despite the stock’s recent decline from $89 to $85 over the last two weeks, the stock feels a tad vulnerable to a retest of $80 in the coming weeks/months.

I am going to wait for a bounce, possibly back to $87, but this is the trade that I would chose here playing for Q2 earnings on July 23rd to serve as the catalyst for a break-down to multi-year lows:

Potential Trade: CAT ($85.25) Buy to Open Aug 85/77.50 put spread for 2.50*

-Buy to Open 1 Aug 85 put for 3.50

-Sell to Open 1 Aug 77.50 put at 1.00

Break-Even on Aug Expiration:

Profits: between 82.50 and 77.50 make up to 5 with max gain of 5 at 77.50 or lower

Losses: up to 2.50 between 82.50 and 85, with max loss of 2.50 above 85

Rationale:  Risking 3% of the underlying stock price to possibly make up to 6% if the stock is down 9% on August expiration.

*IDEAL ENTRY FOR THIS TRADE WOULD BE UP NEAR 87 ON A BOUNCE.