Caterpillar Inc. (NYSE:CAT) issued a warning at the Credit Suisse Industrials Conference yesterday, saying that 2017 sales and EPS had become too optimistic. The lowered guidance came following an epic rally in CAT shares, which had risen 20% from the early November lows.
Although CAT stock closed off its highs, it still managed to close higher on the day. This level of heightened complacency bodes poorly for Caterpillar stock moving forward, especially given the extremes of valuation, with a likely sell-off looming.
In the presentation yesterday, Caterpillar thought that sales estimates for 2017 were too high. This is on top of 47 straight months, or roughly four years, of worldwide sales declines by the company. So CAT stock is certainly at an extreme of a price-to-sales basis, trading at by far the highest level in the past five years.
Price to earnings is also at an extreme at over 90, with CAT stock certainly priced for perfection. While assuredly the Donald Trump administration will be a benefit for industrial machinery companies like CAT, I think the benefit reflected in the recent CAT stock price rally has been grossly overdone.
CAT stock is normally highly correlated to the price of oil, but recently that correlation has broken down. Caterpillar stock is now trading at an extreme to oil prices, even after the most recent huge rally in oil. The weekly chart below highlights this huge divergence, with oil prices basically flat since May while CAT stock has rallied 35%.
Click to Enlarge I look for this divergence to revert, with Caterpillar struggling over the coming month.
Bulls on CAT stock point to the 3.2% dividend yield as a major reason to own CAT stock. Yet little is mentioned of the extreme dividend payout ratio approaching 160%. This level of payout, with dividends far exceeding earnings, cannot continue indefinitely.
So with CAT stock at extremes on valuation, correlation and dividend payout, plus up nearly 20% in November alone, I look for this epic rally to fizzle. With option prices at fairly low levels (26th percentile), long volatility trade structures make sense. So a put diagonal spread to position for a pullback is the way to play.
Trade Idea for CAT Stock
Buy to open CAT Jan $95 puts and sell to open CAT Dec $92.50 puts for a $2.60 net debit.
These are both the traditional monthly options, with January expiration on Jan. 20, 2017 and December expiration on Dec. 16. Ideally, CAT closes near the $92.50 level on December expiration. Maximum risk on the trade is $260 per spread.
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.
