Following an earnings announcement that beat previously lowered expectations on both earnings and revenues, shares of Caterpillar Inc. (NYSE:CAT) soared nearly 5% yesterday.
The company did, however, lower guidance for the second time this year, with the outlook now calling for only $2.75 in earnings per share for 2016 versus a previous estimate of $3 per share in earnings. With CAT stock now trading at the highest valuation levels since the Financial Crisis of 2008, now is the time to short Caterpillar stock.
Technically, CAT stock is getting overbought on a nine-day RSI basis with a reading above 70. Previous overbought readings have marked short-term tops in the past.
Caterpillar has been correlated to the price of oil, which makes sense since its heavy machinery is used in many of the facets of oil production.
Recently, though, that correlation has broken down, with oil dropping and CAT stock moving higher. The last time Caterpillar stock traded at this big of a premium to oil marked a significant high in the stock price.
Fundamentally, Caterpillar stock is trading at an extreme level of valuation, with a price-to-earnings ratio now around 40. This is for a stock that just lowered its guidance.
Apparently lower earnings translates into higher stock prices.
While CAT bulls point to the healthy 3.7% dividend yield, it is important to note the dividend payout ratio has been exceeding 100% over the past year, meaning Caterpillar is borrowing to maintain the dividend. Certainly not a safe dividend for income investors.
Complacency has also reached an extreme, with option implied volatility (IV) now at the lowest level of the year at only 4%. The last time CAT stock saw these levels of implied volatility was a major top in CAT stock.
With Caterpillar stock now trading at an extreme in valuation, extended on a technical basis and overly complacent, a short position in CAT makes sense to me. — especially since the company did jut temper growth forecast with their lowered guidance.
Given the trough levels of IV, option prices are dirt cheap, so a straight put play is the way to position.
CAT Stock Trade Idea
Buy CAT Aug $81 puts at 84 cents to open.
These are the regular monthly options that expire August 19.
I would take some profits if CAT drops to the $78 level, which is the first level of support. Conversely, I would look to reduce the position if CAT breaks our convincingly above the $84 area.
As of this writing, Tim Biggam did not hold a position in any of the aforementioned securities. Anyone interested in finding out more about option-based strategies or for a free trial of the Delta Desk Research Report can email Tim at tbiggam@deltaderivatives.com.
