Last week Caterpillar (NYSE:CAT) reported a terrible quarter as the company lowered guidance, yet the stock proceeded to go up about 5% in the days following the report. Investors are betting that the company is at the bottom of the cycle even as the company offered little positives about the rest of the year. My hypothesis is investors are buying the stock because of its high dividend yield since bond yields are so low. Earning a profit of $2.75 per share for 2016 gives the stock a 30 price to earnings multiple. The only way can justify this valuation is if the cycle turns higher in 2017.
I'm sure investors wish they could just analyze company results in order to get an understanding of where its stock is going. Unfortunately, that became no longer the case with the expansion of central banker's balance sheets which started escalating rapidly in 2008. There have been charts plotting the performance of the S&P 500 in comparison to the Fed's balance sheet. There was an uncanny similarity in performance up until this recent rally as investors have bid the market higher without an expansion of the Fed's balance sheet.
This rally doesn't disprove the Fed's impact on the market. It proves that chart was incomplete because we live in a global world where capital flows freely without any restrictions by borders. The chart below is the complete picture of the market as the JCB and the ECB have made up for the Fed's pause in its expansion of its balance sheet. When European bonds reach negative returns, capital flows to U.S. bonds. Thus, the ECB and the JCB are exporting their policies to America. I think these policies are a legitimate explanation for why Caterpillar stock has been bid up by yield chasers. Investors have to buy high yielding stocks since U.S. treasury yields are at record lows.
The idea that Caterpillar beat expectations makes a mockery of the concept of earnings expectations as each of its main business segments saw declines year over year. Revenues of $10.34 billion may have beaten expectations by $280 million, but they were down 16.1% year over year. Revenues from the energy and transportation division fell 20%. They fell 29% in the resource industries group. Revenues also fell 8% in construction industries.
A summation of Caterpillar's future outlook can be found in the following statement made by Michael DeWalt who is the Vice President of the Finance Services Division. On the conference call last week he said, "I would say that over the course of the past quarter, we're a little more negative on the world economy and the Brexit, Turkey, the elections, oil price, you name it, all of that contributes. And we're less bullish on second half sales because of that." As you can see, he named every excuse possible to explain why the second half would be tough. The outlook worsened from last quarter, yet the stock ignored this and hit 52-week highs.
As you can see from the chart below, GDP is now at its weakest point since the financial crisis. Manufacturing and industrials peaked in 2014 which is earlier than the peak of corporate profits, which happened in 2015. Just because Caterpillar has experienced sales declines for 43 straight months, doesn't mean it will be able to recover in 2017 which is shaping up to be a weak year for the global economy.
Caterpillar's decline is not a part of the normal business cycle at work. Its decline is a part of the unwinding of the commodities super cycle which will never reach its peak levels again. The reason for this is China was the driver of demand for commodities. China is facing a similar demographic problem Japan experienced in 1995. Japan hasn't been able to string together strong economic growth since its working age population stopped increasing in 1995. China's working age population peaked in 2015, so it will never reach the growth rate it has experienced in the previous decades.
In theory investors could simply review what Caterpillar earns at the weakest points and strongest points in the cycle in order to determine the fair valuation of the stock. The reality is investors cannot assume the next up cycle will be as powerful as the last as I proved with the chart showing the demographics of China and Japan. Also, looking at the stock's historical price movement, the stock doesn't stay within a defined range based on what it can earn in various points in the cycle.
The stock trades on sentiment of where the economy will be going in the future along with how the company is able to react to these macroeconomic changes. Being that the stock is trading at its 52-week high, it is clear optimism about the business' potential trough being in place has become the consensus among investors. Bad news is re-interpreted as not mattering because investors are hoping for a recovery in 2017. Based on my analysis of the credit cycle, I believe there will be a recession late this year and into next year. You can see from the chart below how C&I loan delinquency rates have hit recessionary levels. The key to an actual recession will be if and when non-farm payrolls follow them lower. Click to enlarge
Caterpillar reported declining year over-year results, yet the stock reached a 52-week high on optimism relating to the bottom of the business cycle. This optimism goes against the comments made by Caterpillar. It goes against the recent 20% decline in oil prices. It also goes against the first half's GDP growth rate of 1% as well as the increases in C&I loan delinquencies.
Therefore the optimism is unfounded to say the least. Caterpillar will never reach the peak levels of a few years ago because China will no longer be able to drive the commodities super cycle. My guess as to why Caterpillar stock is this high is its dividend yield which far supersedes the 10-year treasury yield of 1.45%. I would rather avoid an overvalued stock no matter what other securities trade at. Caterpillar is a strong sell.
Disclosure: I am/we are short CAT.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.