Credit: Shutterstock photoCAT Bouncing after JPM Upgrade
Caterpillar (CAT) stock price closed at $157.49 on Friday, Feb 2 following broader equity market selloff. Caterpillar already touched an all-time high of $172.99 on Jan 16 after upgrade from JP Morgan a week earlier.
Despite the facto shares are off from the all-time high, Caterpillar stocks have already climbed 70% over the past 12 months while the S&P 500 advanced about 20% during the same period. In fact, the stock was the second-best performing stock in the Dow in 2017, and many analysts see more upside to come
From some of the upgrade analysis you can tell how the investing community has lost almost all common sense perspective in this central banks fueled market rally. For example, UBS bumped up CAT’s target price by 16% one week before JPM. However, instead of top or bottom line growth potential, UBS cited the GOP tax bill could provide around $750 million for share buybacks. When have share buybacks even become an element to recommend a stock? Does that suggest if Caterpillar decides to invest the extra cash for business, UBS would give it a downgrade?
“10-year Upcycle”
JPM at least came up with a stronger argument. According to JPM, the primary driver of CAT shares “in the coming years” is the Republican tax reform bill. Since then, several other investment houses also gave higher price targets for Caterpillar citing GOP tax bill as the catalyst.
JPM argues that the global economy as a whole has entered into a "10-year upcycle" in commodities. Production of iron, coal, copper, and other mineable minerals is rising, and bringing prices along with it. In JPM’s estimate, we're currently entering only year two of this upcycle. That means Caterpillar has nine more years to benefit from the “10-year upcycle”.
Party like It’s 2005
According to JPM, the construction industry could absorb as much as 233,000 annual unit sales of heavy mining equipment, matching peak sales at the top of the last upcycle in 2005.
I’m not sure why investors should get all excited over the possibility of the entire construction industry equipment unit sales back to the 2005 levels? Not to mention it is uncertain how much of the 233,000- unit-sales pie CAT would have?
What’s Really Going on at CAT?
Now let’s take a look at what’s happening at Caterpillar to actually warrant this exuberance.
2016 was a five-year low point for Caterpillar. Its sales were falling for four straight years. The company suffered a 36% drop in earnings in fiscal 2016 citing weak end-user demand in most of the industries it serves, including construction, oil and gas, mining and rail.
Caterpillar managed to rebound in 2017. The company reported this week that its 2017 full year revenue rose 34.7% year over year. Although an improvement, but it is easy comp to the 2016 low’s. While it is still too early to tell, it is enough for investors to conclude Caterpillar has delivered a successful turnaround.
Furthermore, federal agents raided Caterpillar headquarters last March as part of the government investigation into the company’s alleged tax evasion by shifting corporate profits to a subsidiary in Switzerland.
What’s Up with the Tax Reform Write-offs?
Curiously, in its earnings release, Caterpillar indicated “Fourth-quarter 2017 results include a charge of $2.4 billion, or $3.91 per share, from U.S. tax reform legislation.” Earlier this month, IBM also said it took a one-time charge of $5.5 billion as a result of the recent passage of U.S. tax reform.
Perhaps the tax reform could be a negative for all the profits US companies including CAT have stashed offshore? I am not a tax expert, but it is fair to say the “wealth effect” of Trump’s tax reform seems contingent upon a confluence of factors and may not be as abundant as the investing community thinks.
PE at 125, Really
Caterpillar’s Price Earnings (PE) Ratio has gone from 8.81 in 2006 to currently 124.99, compared to 26 for the S&P 500. Typically, the PE of industrial manufacturers should have a PE in single digits to the mid-20s range.
Remember the core business of Caterpillar is making industrial equipment such as tractors, an old-school and mature sector. In addition, CAT is a mature company that has been around since 1925, instead of a tech stock with good growth potential justifying a high-flying PE multiple. Even Facebook (FB) only has a PE of 37 which is only 30% of what Caterpillar commands.
More Like 10-year Tightening Cycle
Furthermore, we are actually in the beginning of central banks’ tightening cycle. The US Fed helicopter is ahead of the monetary easing curve after the 2008 global financial crisis, and again is ahead of the coming global tightening cycle. Expect other central banks to eventually follow suit (it is safe to say within the next 10 years).
A business cycle typically lasts about 8-10 years. The current business cycle began from the 2008 financial crash/monetary easing and has already pushed into uncharted territory. I’m not sure how JPM could realistically model the “10-year upcycle” projection given the current lofty valuation on almost all asset classes and the increasingly high risk of war and recession.
Technical and Cash Trading
How could a scandal-ridden tractor-making company become such a darling for investors? Well, that’s just one indication that markets, along with investors, are not behaving normally and rationally.
Even central banks like SNB made $55 Billion last year by purchasing international stocks and bonds. This is equivalent to massive hedge funds backed by various governments manipulating the markets for its own agenda. This is like an addictive drug high that everybody is on, but eventually the high will come to a very nasty crash that investors refuse to acknowledge.
In this irrationally crazy market where a name change incorporating the word “blockchain” could rescue an ice-tea-making penny stock from being delisted on NASDAQ, company fundamental analysis and macro event trading have become all but useless traps. The suitable stock trading style that I believe could survive this current environment is technical and momentum cash only trades based on solid research and charting.
Caterpillar along with the entire equity market all have a long way to go before valuations are down to the historical norms. Who will be left holding the bag? Everybody, when awakened by the sudden burst of this unprecedented bubble that would make 1929 a cake walk.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
