Smart Money Betting on Heavy Machinery Stocks

One of the greatest assets you can have as a trader or investor is having the ability to spot trends, and use that information to draw conclusions about what will occur in the future.

I have long used the options market as a way of watching where the “smart money” is making bets. It has allowed me to foresee the collapse of financial stocks and the re-emergence of oil and commodity related stocks.

And from the signals I’m seeing, we may be on the verge of another big move.

Over the past few weeks, large volume bullish option trades have been indicating the expectation for a major recovery in heavy machinery stocks for the third quarter of 2009.

But we can’t really understand the significance of these trades without looking at the big picture first.

Industrial SPDR (NYSE: XLI) stocks have a very high correlation with the broader markets – it’s why they call it the Dow Jones Industrial Average – and to even a large extent, the economy. You can simply look at a chart of the XLI versus the S&P 500 (.INX) for confirmation.

But it’s more than visual similarity, its fundamental.

Economic data such as GDP growth, ISM Manufacturing Index, Industrial Production, and Capacity Utilization are all industrial based figures that give us clues to where the economy is heading. And although we are still seeing weak economic numbers, all signs are pointing to recovering indicators.

Heavy machinery is an integral aspect to increased economic production. These are the machines that will pump more fuel, dig more minerals, refine more metals and ultimately produce the materials that we make everything else from.

There has been lots of talk about inflation recently. And it’s not hard to see why. Historically, when nations printed lots of new money – like they are now – inflation has occurred.

The anticipation of inflation has sent commodity stocks soaring. And as a result, the heavy machinery companies, which make the products to bring gold, oil, silver, copper, and agricultural soft commodities out of the ground, have become very interesting.

Following the Smart Money in Heavy Machinery

One of the first bullish large dollar bets came on May 20 in a lesser know company, Illinois Tool Works (NYSE: ITW), a diversified machinery company that makes products ranging from construction tools to ventilation systems in kitchens.

The trader used a ratio call spread, a strategy bearish on volatility and in this case bullish on price, to buy 2,000 September $30 calls and sell 6,000 September $40 calls. This was a $600,000 bet that shares of the company rise past $40, and as high as $43.50 by September of this year. Shares traded at $34 on the day of the transaction and are now at $37. So there is still plenty of upside to this trade.

Even more tantalizing were some of the trades from last week.

A June 3 earnings conference call by Joy Global (Nasdaq: JOYG) seemed to be the catalyst the spurred much of the bullish activity in the farm and construction machinery firms this past week. Their comments suggested a pickup in the economy and that orders are stabilizing.

In another example, CNH Global N.V. ADR (NYSE: CNH), a producer of agricultural and construction equipment with much of its sales outside the United States, had increased bullish buying of its options. Specifically the September and December call options at the $22.50 and $25 strike prices on June 4 –these trades looking for more than a 30% increase in shares over the coming months.

Ingersoll-Rand Company (NYSE: IR) traded nearly 10,000 out-of-the-money July $22.50 and $25 calls on June 5. These multiple 1,500 contract blocks were expecting near term upside in shares of the air conditioning and security services industrial company.

Caterpillar (NYSE: CAT) traded a 11,600 contract block of August $40 calls with shares at $38, while a large diagonal calendar call spread traded later in the day on June 5. The trade resulted in the selling of 15,000 August $42 calls to finance the purchase of 15,000 November $45 calls, a $570,000 bet that can yield unlimited profits.

For those of you who aren’t familiar with the intricacies of options contracts: put simply, there is a lot of money being bet on a recovery in heavy machinery and these industrial firms over the next few months.

Playing a Boom in Heavy Machinery

In addition to the government stimulus dollars being pumped into the system to spur construction spending, the resurgence of the commodities sector will lead to a surge in heavy machinery stocks for the remainder of 2009. And while there are a number of ways to play heavy machines, but the best way may be to diversify across the three major production categories.

Agricultural/Commodity Machinery

• AGCO Corp (Nasdaq: AGCO)
  
• Bucyrus (Nasdaq: BUCY)
  
• Joy Global (Nasdaq: JOYG)
  
• Dresser-Rand (NYSE: DRC)

Construction

• Deere & Co (NYSE: DE)
• Caterpillar (NYSE: CAT)
• Illinois Tool Works (NYSE: ITW)
• ITT (NYSE: ITT)
• Dover (NYSE: DOV)
• Emerson Electric (NYSE: EMR)
• Pall (NYSE: PLL)
• CNH Global N.V. ADR (NYSE: CNH)
• Ingersoll-Rand Co Ltd (NYSE: IR)

Suppliers

• Timken (NYSE: TKR)
• Kaydon (NYSE: KDN)
• Stanley Works (NYSE: SWK)

Unfortunately, right now many of these names are overbought as you can see in the RSI (Relative Strength Index) provided in the table below, so the best suggesting is to buy dips and pullbacks for most.

Valuation in many of these firms is at record lows, take a look…

You can see from the key metrics above that while these companies may be a little on the pricey side, they still represent very good long-term value.

As economic production ramps up and equipment is needed to build and maintain our infrastructure, construct new projects, and mine commodities, industrial stocks are likely to see the most benefits and outperform the market in the coming months

Smart money is flowing in to the group, and if you want to be ahead of the trend, I suggest owning a few of the aforementioned stocks for this economic recovery that economic figures are pointing towards.

Disclosure: Own call options in Ingersoll Rand (IR)

Comments

[buoy:]

This is sort of a "no-brainer", being that the rest of the world is in the process of modernizing. You should have included GE in your list.

Jun 10 09:14 AM

[Joe Kunkle:]

GE is a conglomerate with exposure to financial, appliance, and even alternative energy industries. Not a pure play that I would include here.


On Jun 10 09:14 AM buoy wrote:

> This is sort of a "no-brainer", being that the rest of the world
> is in the process of modernizing. You should have included GE in
> your list.

Jun 10 11:12 AM

[buoy:]

Ahhh... "pure play"...I see :)

Jun 10 02:45 PM

[bones33:]

What about TITN titan machinery.Small cap with low PE and solid financials.

Jun 10 07:41 PM

[Duble1:]

Could add Kubota, as well, to the list.

Jun 10 11:54 PM