Caterpillar and Deere Showing Leadership

 |  Includes: CAT, DE, DIA, QQQ, SPY
by: Leigh Drogen

Trading is all about patterns, whether you are a fundamental investor or short term technical day trader. Maybe you study the very cyclical nature of the semiconductor business, buying high beta names when demand looks at its worst and swapping in to lower beta higher market cap names when demand is extremely high. If you’re a technical trader you look for patterns like multi month bases or flags. Maybe you’re a global macro trader and you make your living following the ebb and flow of capital around the world.

We all play patterns, we’re not here just throwing darts at a board (well some of us aren’t at least). We learn these patterns in three ways. You can either be a savant, like John Lee who instinctively understands patterns and has internalized so much of it that it has become second nature. These people are the same as the math geniuses who can do linear regression in their head or tell you how many marbles are in a jar. We learn patterns just from experience, being around the market enough, standing in the pit or sitting in front of the screens. And finally, we learn pattern recognition from our mentors who pass along their knowledge to us. Internalizing what is taught is extremely difficult. Not everyone can be taught, it takes a certain type of brain and a certain disposition to learn different things. I can’t learn languages to save my life, it’s just not how my brain works.

Anyway, certain patterns are harder to learn on your own, or just aren’t intuitive like technical pattern recognition. One of the best lessons I was taught by my mentor was that one, big cap stocks like IBM and Intel (NASDAQ:INTC) do not move quickly. He used to call it the cruise liner theory. It takes a lot of time and effort to turn a cruise liner around and head in the other direction. A lot of water has to be moved out of the way of that hull which has a large draft. The same can be said for big cap stocks. Institutions don’t just dump stock all at once, there’s too much of it. They feed it out into the market in little pieces. If it get’s knocked down too hard too fast, they will actually go out and buy some to support the price, so that they can unload more stock at higher prices.

So if you’re an investor in these stocks, save for some unforeseen and very strange piece of news connected with the company, like a CEO quitting, or an accounting scandal, don’t freak out when the stock gaps down 5% on earnings, it’ll most likely close the gap. If you’re looking to take the short side of one of these names, wait until all of the major moving averages have rolled over, topping out is a huge process for these names, not an event.

Do I believe we are at that point now, where these names are topping out? Well until a few days ago it was front and center in my mind. But certain events over the past couple of days have changed my view a bit.

Yes, it’s ok to change your views on the market, don’t for a second think that means I’m being wishy washy about my stance. In fact, having a stance on the market isn’t always necessary. Sometimes cash is the best position and being completely agnostic regarding direction is best. Economists are payed to have views, traders are payed to make money, it’s as simple as that.

Two things turning my head in the past few days are the action in Deere (NYSE:DE) and Caterpillar (NYSE:CAT). Another great lesson taught to me was that CAT is an amazing bellwether for the market and the economy. Why? Because CAT and DE give insight into several different segments of the economy, and risk in the market. First, they represent heavy machinery manufacturing, something we don’t do a lot of anymore in this country. Second, orders for this machinery are very tied to commodity prices and global economic growth. If miners are making a ton of money and expanding, they are ordering this stuff, if not, they aren’t making the capital investment in the heavy machinery. Third, because they use so much steel, their input cost gives a good gague on inflation and overall demand.

So when we see these two companies seeing high demand for their products, pricing power, stock prices that are climbing, and a healthy bottom line, you can bet the global economy isn’t doing too poorly. When they see orders drop, have to lay off workforce, see their input costs plummet, you can bet we’re having trouble around the world.

Over the last few weeks CAT and DE have shown great leadership in terms of price. These are very cyclical names and you should be paying close attention to how they act. If they break out now and run, another leg to this rally could be at hand. These two have the power to pull the rest of the market with them.

Yes, the global macro environment is still crappy. The domestic economic numbers look even worse. But don’t disregard the action in these two names, you’ll find yourself on the wrong side of the market.