Shares of Caterpillar Inc. (NYSE:CAT) had quite a 2017, rising nearly 70% for the year. This made Caterpillar the second-best-performing Dow Jones Industrial Average stock for 2017. CAT also closed out the year just barely off the all-time highs of $158.42. The rally, though, is starting to look a little overdone at current levels. I expect Caterpillar to consolidate and have trouble heading appreciably higher over the coming few weeks.
While Caterpillar has certainly been on a major rally until the past few days, the fundamentals certainly aren’t supportive of such a move higher. Price to sales (P/S) ratio now stands at well over 2 and at by far the highest level over the past 10 years, as seen in the chart below. CAT now sports a market cap of $93.43 billion with 2017 revenues expected to be $44 billion.
Using a more historically realistic P/S ratio of 1.2 means that CAT would need to have $78 billion in annual revenue ( or a nearly 77% increase!!) to justify current valuations.
CAT is also under renewed scrutiny by both the Commerce Department and IRS regarding the tax avoidance scheme run through Swiss based Caterpillar SARL. The company effectively pays only a 4% tax rate on foreign profits versus the new 21% corporate U.S tax rate by employing this subsidiary to book profits. A potential $2 billion tax liability is at stake, which should provide some upside resistance to shares.
Caterpillar is also looking overbought on a technical basis. 14 day RSI recently breached the 80 level, which had previously marked a significant short term top in the past.
Yesterday’s price action, with CAT stock making a new all-time high at $159.39 intraday only to reverse course and close lower, points to a potential reversal day. Buyers may finally be showing signs of fatigue at current price levels.
Implied volatility (IV) is at the 58th percentile, meaning option prices are still somewhat expensive. This makes makes option selling strategies viable. So to position for a period of consolidation in CAT stock, a bearish out of the money call spread makes intuitive sense.
Buy CAT Jan $162.50 calls and sell CAT Jan $160 calls for a 50-cent net credit.
Maximum gain on the trade is $50 per spread with maximum risk of $200 per spread. Return on risk is 25%. The short $160 strike price is above the $159.39 all-time high in Caterpillar and provides a 1.9% upside cushion to the $157.04 closing price of CAT stock.
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 firstname.lastname@example.org.