🗞 Dollar Tree is Back?

WHILE YOU POUR THE JOE… ☕️
Credit Where it’s Not Due

In his last few stunts as president, Biden has taken credit and expected a pat on the back for lowering prices for the Thanksgiving basket.

The thing is, these indexed prices are still more than double what they were since he took office.

So, it’s not really fair to point the finger at the Trump tariffs, which could potentially bring inflation, when they aren’t even here yet.

In fact, if you read our last issue 👀, you know that the market is rotating down into a recession theme from the previous inflation one.

Speaking of market rotations, let’s get on with today’s email 📧…

OPEN THE HISTORY BOOKS
Bringing Back Memories

Back in 2018, when I was just a handful of years into my trading journey, I understood the importance of monitoring intermarket relationships, especially between the main asset classes like stocks and bonds.

With this little understanding, I noticed that the spread between the NASDAQ 100 and the ten-year bonds were deviating to a peak, which you can also see for 2018 in the image above.

What followed then was a couple hundred point selloff in the $QQQ, driven by the Federal Reserve cutting interest rates by only 0.25% when markets expected to see 0.50% instead. 📉 

We’re now back to that same setup, only bigger and wider. As you can see, the spread has reached an all-time high.

Again, if you read our last post, you know the price action in the S&P 500 and TLT bond ETF signals a potential recession.

Here’s another one: the S&P 500 in orange versus the spread between ten-year bonds and corporate bonds, also known as equity risk premiums.

When this spread (in white) trends lower, the risk of owning stocks becomes higher, so you need to watch out for potential catalysts that could bring the market down.

This trend, on top of the deviations between the index and the bonds, could pose a potential risk to the S&P 500 keeping and maintaining the all-time highs it has gotten to today. 💥 

Here’s another: the manufacturing PMI index, which has been contracted for 24 months, usually is a typical way to gauge where the S&P 500 might be headed next.

With a usual 12-18 month lag between the S&P 500 and the PMI, this 24-month setup could mean the index is overdue for a pullback soon. 📉 

You’ve been warned, fundamentally and technically.

 TRADE OF THE WEEK
Asymmetries are Reborn

This isn’t the sexiest business out there, but it might be one of the sexiest setups today.

Out of the past 12 months, most of the volume in Dollar Tree stock took place around the $66-$67 area, and this is a sign of institutional accumulation ahead of a potential jump.

Where and why that jump is coming from is our homework today, and the conclusions seem more than optimistic and enough to put some capital into this options trade setup.

Similar to our pitch a few weeks ago on Estee Lauder, this setup could prove to be a 10:1 trade. 📈 

On a valuation basis, the market is definitely discounting Dollar Tree in all accounts, a first sign of potential underlying weakness. 📉 

However, that might soon take a turn, especially as it is the one looking to grow its earnings per share (EPS) the most, second to only Burlington Stores.

The low valuation next to the high EPS growth potential gives us a great forward PEG ratio, so the risk is minimal compared to what the stock could do, which in this case is try to pull off a double.

While the initial financials looked awful, we did notice a few drivers starting to diverge in a good way.

Dollar Tree is opening a lot more stores, and sales per square footage are going up with their location expansion, so it’s not a one-sided equation here.

But

You need to keep in mind that Dollar Tree also owns Family Dollar, since 2015, but it’s now making management think twice about keeping it. 🧠 

Dragging the brand lower, Family Dollar is now the subject of a sale or spinoff, which might bring a potential special dividend to shareholders and also boost the stock price. 📈 

More than that, Dollar Tree is using its increasing cash flow to acquire 99 Cent Stores near bankruptcy, getting a great deal through rock-bottom lease rates.

When the mark-to-market boosts the valuation of these leases, and the newly converted Dollar Tree stores help boost the overall margin for the brand, higher EPS and cash flow could bring us to new highs. 👀 

Then there’s the rally in the $TLT bond ETF calling for lower yields and interest rates.

Even if the yields are coming down for the wrong reasons, that being from a recession, it will be a good thing for brands like Dollar Tree, which tend to benefit from tougher economic times as people see their products as a solution.

We think this could be the reason why most of the year’s volume happened here at the $66-$67 level 🎯, as judged by the red bar.

There are reasons to believe this is a sign of institutional accumulation, and we know exactly who bought there.

State Street built its way into a $663 million position 💵 in Dollar Tree stock during the second week of November, but we don’t just want a boring ride higher; we want the big payoff.

So we looked to the options market, where the current volatility curve says the highest the stock can reach is $105 by May 2025.

However, most contracts in the market are set for June 2025 at a $140 strike. That means, if the stock happens to get there, its volatility would be an implied 105%, compared to the options for $140, which trade at only 62.9% volatility. 👀 

So, valuing these options through a Black-Scholes model, we should be paying at most $1.75 per contract, though if we can get a better entry point closer to the $66-$67 VPOC range, even better.

All told, if the stock manages to rally above $105 before May of 2025, it would have successfully broken the implied volatility curve, meaning these options could be worth upwards of $9.0 each, a near 10:1 trade based on sound fundamentals. 🫰 

NOW GO AND MAKE IT HAPPEN
One Big Machine

Going back to the concept of intermarket analysis, which brings us to believe that the S&P 500 might be overdue for a selloff soon, today’s book recommendation 📖 was the one that helped me understand how the different asset classes interact with each other and what their price action means.

To your success,

G. 🥃