Market Overview
After a negative start to the week last Monday, the market surged higher on Wednesday, following what many traders view as a “less hawkish” speech by Federal Reserve Chairman Jerome Powell. By week’s end the S&P 500 had gained 1.1%, the Dow had added 0.37%, and the Nasdaq had rallied 1.99%.
Unfortunately for the bulls, the momentum from last week was quickly washed away yesterday as the indexes fell sharply.
This week we are adding to the portfolio Gap (GPS), which recently beat earnings expectations.
The Stock – Gap (GPS)
Why the Strength
There are plenty of bears hovering around this beaten-down retailer, but they may have oversold the fact that people still buy jeans and casual clothes at Gap stores and Old Navy locations. Third-quarter results, reported in mid-November, destroyed pessimistic estimates, with the company posting a 1% same-store sales increase in the period when a decline of 2% was forecast, while earnings of 71 cents per share easily outpaced expectations of a breakeven quarter.
There was still weakness in Old Navy, which accounts for just over half of sales (Gap, Banana Republic and Athleta are its other brands). Yet, Old Navy’s same-stores dropped 1% against a Street-forecast 4% slip, and metrics like expanding gross and operating margins have given fresh air to bulls.
Bears point to heavy discounting as a factor in better sales, but management counters that eliminating inventory gives the business a reset for next year. Basically, a lumpy pandemic supply chain and missteps by management left the company with too much fleece and sweaters and too little of items people feel comfortable wearing in their return to the office. Gap says slashing prices to get goods out is part of its plan to restock as its manufacturing efforts shift to the Americas and away from Asia to balance out supply needs.
The lack of a permanent CEO (Sonya Singal stepped down in July) hurts the narrative that Gap’s turnaround is underway, as do expectations the current quarter will be weaker. But there’s a growing feeling the worst has passed, or close to it—analysts see fiscal 2024 (which starts next February) bringing a small sales gain and earnings of 80 cents per share, both of which could prove conservative.
Technical Analysis
GPS got crushed from May 2021 through June 2022, falling from a peak near 35 to a low in the 8 area. The bounce in the summer was weak, but the retest in September held—and, really, since then GPS has been extremely impressive, advancing steadily to 12 and showing an accelerated upmove to 15 before and after earnings on giant volume. Stop – 11.9
The Covered Call Trade
Buy Gap (GPS) Stock at 15, Sell to Open December 15 Strike Calls (exp.12/16) for $0.45, or a Net Price of 14.55 or less
Static Return: $45 per covered call (3.09%)
Breakeven: 14.55
Covered Call Return (if assigned): $45 per covered call (3.09%)
Please note, the stock and options prices will be moving throughout the day, so these prices are simply an approximation of prices that you should be able to achieve.
However, the important component of this equation is that the stock price paid, minus the premium received via the call sale, equals the Net Price, or 14.55 or less. (In this case 15 minus 0.45 = 14.55. Or another example is you could pay 15.25 for the stock and sell the call for 0.70, which also equals 14.55)
For every 100 shares of stock you buy, you can sell 1 call. For every 200 shares of stock you buy, you can sell 2 calls. And so on …
Open Positions
If our stop is hit, I will send an alert giving detailed instructions on how to exit the trade. But don’t get too worried about setting the stop. I will manage that for you.
The next Cabot Profit Booster issue will be published on December 13, 2022.
