Chewy Stock Looks Like a Tasty Discount. The Truth Requires Traders to Have More Caution.

At some point, investors need to call a spade a spade, which brings us to pet e-commerce specialist Chewy (CHWY). Fundamentally, the appeal of the business is rather obvious: Americans love their four-legged friends. They also love convenience, as evidenced by the rise of Amazon (AMZN). Combine these two elements together and you should have a strong bullish case for CHWY stock.

Unfortunately, that narrative has simply not panned out. Shares are down nearly 44% on a year-to-date basis, leading the Barchart Technical Opinion indicator to downgrade CHWY stock as a 100% Strong Sell. With this kind of negative performance, it’s difficult not to view Chewy as a falling knife.

Still, because of the damage inflicted, there’s undoubtedly a lingering question that arises: is CHWY stock a compelling discount? On paper, it’s an attractive proposition. Right now, shares trade at almost 31-times trailing-year earnings. Compare this stat to the end of October last year when the metric stood at nearly 94 times and you get an immediate sense of a value dip.

However, these numbers can be misleading. Primarily, the problem is that Chewy is no longer a hot growth machine, which is expanding its top line at around 6% to 7%. As such, even a 31x multiple may be deemed excessive, especially when compared to mature retail peers that share the same plateaued growth rate.

Of course, that’s not to say that Chewy can’t climb out of its slow-growth funk. However, this situation demonstrates that relying solely on earnings multiples can be deceptive when attempting to uncover potential market discounts.

Using Conditioned Data to Trade CHWY Stock

Now, one of the persistent adages in the market is that retail traders should consider buying the blood on the streets; this is the Warren Buffett maxim of being fearful when others are greedy and greedy when others are fearful. But let’s be honest here. If investing were that easy, the market wouldn't have a graveyard full of contrarians who went broke trying to buy the dip.

In my opinion, the only way to mitigate the risk of contrarianism going badly wrong is to condition observed trading signals relative to a baseline aggregate performance. If the signal statistically yields better results than the baseline, you may have (nothing is guaranteed) an exploitable opportunity.

Let’s consider an empirical example. Using available data since CHWY’s market debut, if you were to buy and hold shares for a 10-week period (with an entry price of $18.55 and without any attempt to time the market), your nominal return would, on average, land somewhere between $18.25 and $18.65. Since most of the probability mass of this forward distribution would be below the starting point, CHWY stock suffers from a near-term negative bias.

Subsequently, if you wanted to trade Chewy as a bull, the signal upon which you are trading must deliver results better than this random baseline; otherwise, there would be no point. Currently, the trading signal is negative. In the past 10 weeks, CHWY stock has printed only two up weeks, leading to a downward slope.

Conditioned for this particular sequence, the forward 10-week distribution of CHWY is actually worse than the baseline. Traders who bought this 2-8-D signal (two up weeks, eight down weeks, downward slope) would typically expect to see a forward distribution between $16 and $19.50.

To be fair, this conditioned distribution features greater upside potential when things go right. The problem is, more often than not, when this signal flashed, contrarians suffered a worse outcome than simply buying CHWY stock randomly. Therefore, it’s not mathematically possible to say that this current setup is a high-probability discount.

A Conformist Opportunity?

I’m not going to get into any long-term prognostications of CHWY stock because I simply don’t know. Chewy can always make a turnaround; that’s never not in the cards. However, if we’re looking at the short-term picture, the pet retailer might offer conformists or trend followers an interesting opportunity.

Based on an inductive model of past market behaviors, whenever CHWY stock flashed the aforementioned 2-8-D signal, the security has tended to steadily erode value over the next six to seven weeks before rising in the last three weeks of a forward 10-week period.

If we were to assume a similar pattern, the 18/17 bear put spread expiring Aug. 7 may be in play. Basically, the $17 strike falls within the expected forward distribution when conditioned for the 2-8-D signal. And while the Aug. 7 expiration date is cutting things close, this spread is banking on the observation that CHWY stock tends to rise in the latter period of the distribution.

I want to be clear that inductive models are not predictions: no one knows the future. That said, the next best alternative is to recognize patterns conditioned on specific criteria. In the case of CHWY stock, at this juncture, the data points to a conformist opportunity, not a contrarian one.