This Stock’s Decline Echoes Bad Economic Trends
Source: Toll Brothers.com
Economists think of the economy as a large ship, in some ways. On the open seas, a large ship takes times to turn. It needs to move slowly in order to avoid toppling over. It also turns slowly to avoid shifting cargo and passengers with a sharp turn.
Slow turns are also a characteristic of the economy. It’s rare that a crisis appears suddenly. Even in 2008, although the collapse of the credit market came suddenly, the signs were in place months before the economy turned. Investors and analysts overlooked the warning signs.
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Now, some economic indicators are flashing warning signs and many investors and analysts are once again ignoring them. The chart below shows some of the warning signs.
This shows Moody’s economic “adjusted” performance measures for credit cards, auto loans, and mortgages (effectively a risk measure). Moody’s is a credit rating firm and its experts track dozens of indicators on the economy. They create proprietary indicators like the ones shown in the chart.
This chart shows auto loans are behaving as they do in a weak economy. Credit card debt is also warning of weakness and home loans just turned out of the strong economic performance zone.
Overall, the Moody’s data is warning of possible problems in the economy. Some stocks are confirming the trend.
A Home Builder Misses Estimates
U.S. luxury homebuilder Toll Brothers Inc (NYSE: TOL) missed Wall Street estimates when the company reported earnings for the second quarter. Management noted the company was hurt by higher costs due to rising prices for building materials and shortages of land and skilled workers.
Costs rose 20.5% to $1.29 billion in the quarter and adjusted gross margins slipped to 22.5% from 24.3% a year earlier. That number narrowly missed the homebuilder’s forecast of 22.8% for the quarter.
“Home ownership and household formation rates are increasing, while supply remains constrained,” Executive Chairman Robert Toll said in a statement.
The U.S. housing market is yet to fully recover from the long-term damage of the subprime crash a decade ago. Many homebuilders are also fighting rising costs and labor shortages even though demand is picking up.
Orders, an indication of future revenue for homebuilders, rose 6.2% to 2,666 homes.
The Pennsylvania-based company said the average price of homes rose to $847,900 from $832,400 a year earlier, while the number of homes sold rose to 1,886 from 1,638 in the quarter.
The company raised its forecast for the number of homes it expects to sell in fiscal 2018 to between 8,000 and 8,500 units, from between 7,800 and 8,600 units.
Toll Brothers also raised the lower end of its full-year average price forecast to $830,000 from $820,000 but kept the higher end unchanged at $860,000.
Homebuilders PulteGroup Inc and Lennar Corp have also raised their annual home sales forecast, indicating homebuyers’ optimism around an improving economy despite rising home loan rates.
Net income fell to $111.8 million, or $0.72 per share, in the quarter ended April 30, from $124.6 million, or $0.73 per share, a year earlier, with the company recording an inventory charge of $13.8 million.
Revenue rose to $1.59 billion from $1.36 billion a year ago.
Analysts on average had expected a profit of $0.76 per share are and revenue of $1.58 billion. The stock gapped down on the news.
Given the current state of the economy, a recovery seems unlikely in the short term.
A Trading Strategy to Benefit From Potential Weakness
The prospects of a short term rebound in TOL seem to be remote. Traders should consider using an options strategy known as a bear put spread to benefit from the expected downward price move.
This strategy can be profitable when a trader is looking for a steady or declining stock price during the term of the options. The risks and potential rewards of this strategy are illustrated in the payoff diagram shown below.
Source: The Options Industry Council
A bear put spread consists of buying one put and selling another put at a lower exercise price to offset part of the initial cost of the trade. This trading strategy generally profits if the stock price moves lower. The potential profit is limited, but so is the risk should the stock unexpectedly rally.
The Trade Specifics for TOL
The bearish outlook for TOL, at least for the purposes of this trade, is a short term opinion. To benefit from this outlook, traders can buy put options.
A put option gives the trader the right, but not the obligation, to sell shares at a specified price until the option expire. While buying a put is possible, it can also be expensive. The risk of loss when buying an option is equal to 100% of the amount paid for the option.
To limit the risks, a second put can be sold. This will generate income that can offset the purchase price, potentially allowing a trader to buy a put with a higher exercise price. That increases the probability of success for the trade.
Specifically, the June 1 $40 put can be bought for about $0.90 and the June 1 $38 put can be sold for about $0.20. This trade will cost about $0.70 to enter, or $70 since each contract covers 100 shares, ignoring the cost of commissions which should be small when using a deep discount broker.
The amount paid to enter the trade is the largest possible loss on the trade. This is generally true whenever a trader is creating a debit to enter an options trade. “Creating a debit” means there is a cost to enter the trade. You could create a debit by simply buying puts or calls to open a directional trade.
In this trade, the maximum loss would be equal to the amount spent to open the trade, or $70. This loss would be experienced if TOL is above $40 when the options expire. In that case, both options would expire worthless.
The maximum gain on the trade is equal to the difference in exercise prices less the amount of the premium paid to open the trade.
For this trade in TOL, the maximum gain is $1.30 ($40 – $38 = $2.00; $2.00 – $0.70 = $1.30). This represents $130 per contract since each contract covers 100 shares.
Most brokers will require minimum trading capital equal to the risk on the trade, or $70 to open this trade.
That is a potential gain of about 85% of the amount risked in the trade. This trade delivers the maximum gain if TOL closes below $38 on June 1 when the options expire.
Put spreads can be used to generate high returns on small amounts of capital several times a year, offering larger percentage gains for small investors willing to accept the risks of this strategy. Those risks, in dollar terms, are relatively small, about $70 for this trade in TOL.