Economic concerns are raging amid a volatile third-quarter earnings season, with Sprouts Farmers Market Inc (NASDAQ:SFM) suffering a devastating blow. After the organic specialty grocer delivered disappointing financial results and underwhelming forward guidance, investors rushed for the exits, sending SFM stock down about 26%. Amid the wreckage, however, SFM has also flashed a rare quantitative signal that could point to upside in the weeks ahead.
Right now, investors are clearly not looking beyond the horizon — and really, no one can blame them. Sprouts posted earnings of $1.22 per share in the third quarter, which did beat analysts' consensus target of $1.17. Unfortunately, the focus was squarely on the top line, with the company generating sales of $2.2 billion. This figure missed the consensus target of $2.225 billion, which raised an ugly fundamental question.
Theoretically, due to Sprouts specializing in organic products, the brand caters to a higher-income crowd. As such, you would reasonably expect some level of insulation from broader economic pressures. That hypothesis did not hold, which left SFM stock reeling from panicked investors.
What may have really triggered the selloff, though, was the guidance. Management anticipates fourth-quarter adjusted earnings to land between 86 cents to 90 cents per share. Glaringly, this range clashed with analysts' consensus target of 98 cents.
Unsurprisingly, the analyst community — which presently features a neutral rating on SFM stock — trimmed its expectations. Right now, the consensus price target is $121.28, whereas the highest price target is $190, set by Deutsche Bank on March 17 of this year.
While circumstances do look ugly, there may be an opportunity for risk-tolerant speculators to go contrarian on SFM stock.
Playing The Statistical Game Of SFM Stock
While analysts' skepticism toward Sprouts represents a common fear, it's also helpful to realize that these experts are using fundamental analysis. But despite the term, the methodology is not a real analysis but merely an opinion. How do I know this? Because real analyses don't feature wide variances in expectations.
Among Wells Fargo, RBC Capital, Goldman Sachs and Evercore ISI Group, the high-low spread of analyst price targets prior to earnings stood at 21.6%. That can be somewhat explained by differing interpretations of fair value. Following earnings, though, the spread only narrowed to 16.9%. So, even with everyone looking at the same devastating data, the differential barely budged.
You see it with your own eyes. Fundamental (or technical) analysis is contingent on the analyst making the claim. That's an awfully brittle approach because you never know when the analyst is about to go on a bad streak (they always do). There's a better way — especially when it comes to options trading — and that's the quantitative approach.
Quantitative analysis is the empirical study of price behavior and it's anchored to observations made by GARCH (Generalized Autoregressive Conditional Heteroskedasticity) studies. GARCH solidified the diffusional property of volatility as non-linear, clustered phenomena.
In human language, the takeaway is simply this: different market stimuli yield different market behaviors.
Under baseline conditions (using data pulled from January 2019 onward), the expected 10-week returns of SFM stock will form a distributional curve, with outcomes mostly ranging between $74 and $85 (assuming an anchor price of $77.18). Further, price clustering — or the distribution's center of mass — is expected to be predominant at roughly $79.
However, we're not under baseline conditions. Instead, in the trailing 10 weeks, SFM stock printed a 2-8-D sequence: two up weeks, eight down weeks, with an overall downward slope. With this context, SFM's risk-reward tail expands to $63 on the low side to $107 on the high.
Here's the nuance: price clustering will be predominant at $79, maybe even lower at $78. However, there's a secondary clustering that will be predominant at around $90 and that's the opportunity. With a little luck, we could be looking at a 13.9% positive delta in price density dynamics.
Is any fundamental or technical analyst talking about density dynamics? No, they're not. They're bedtime storytellers, not data scientists.
A Long Shot That Makes Sense
Earlier, I said that price clustering under 2-8-D conditions could be lower at $78. That's because we should expect choppiness — an observation from past analogs — in the first several weeks. However, from the sixth week onward, we may see the bulls emerge and bid up SFM stock. That's where the higher secondary clustering comes into view.
Again, just to drive home the point, there are no fundamental or technical analysts talking about these density dynamics, even though these are observable, quantifiable phenomena. These methodologies are completely blind to these signals because they're contingent on the author making the claim.
Getting back to SFM stock, please notice that the 80/90 bull call spread expiring Dec. 19 features a massive maximum payout of roughly 223%. Yes, this trade will require SFM to rise through the $90 strike price at expiration but the secondary density data shows that this is a realistic target.
Also, breakeven for the above trade is $83.10. That is very realistic, so long as the historical response to the 2-8-D sequence pans out as expected. While Sprouts is undeniably a risky proposition, there's an empirical case to be made here if you simply run the numbers.
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