Caterpillar: More Downside Than Upside

| About: Caterpillar Inc. (CAT)
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Summary

Caterpillar share price is up by 50% since my bullish article from February 2016.

The shares are too expensive now.

Caterpillar's P/E ratio is 4 times higher compared to its closest peers, Deere & Company and Komatsu.

Caterpillar needs EPS of more than $4 to validate the current share price. The company expects EPS of only $2.3 in 2017.

The current share price is supported only by the strong commodity and U.S. stock markets. Any weakness may initiate a major correction in Caterpillar's share price.

Caterpillar (NYSE:CAT) share price grew by 50% since my bullish article published in February 2016. Back then, I expected that growing commodity prices will push Caterpillar's shares higher. But I didn't expect that the share price growth will be so quick and steep. Caterpillar is trying to break the $100 mark right now and given the current commodity prices and positive outlook for some of them, it is quite possible that share prices over $100 will be reached soon. On the other hand, the stocks got too expensive. A correction is only a question of time and I see more downside than upside for Caterpillar right now.

CAT Chart

CAT data by YCharts

The chart below shows Caterpillar's share price and Caterpillar's EPS over the last 10 years. As can be seen, the share price moved in the same direction as EPS, most of the time. The share price curve was also able to signalise a bottom or a peak of the EPS curve, several months in advance. But in early 2016, the share price started to grow strongly, while the EPS kept on declining.

CAT Chart

CAT data by YCharts

The combination of growing share price and falling earnings resulted into a hugely inflated P/E ratio. Caterpillar's P/E ratio climbed up to 90. For comparison, Caterpillar's main competitors Deere & Company (NYSE:DE) and Komatsu (OTCPK:KMTUY) have P/E values of 22.82 and 17.30 respectively. It is able to expect that Caterpillar's P/E will decline back to the 20-25 range. There are only two things that can push the P/E value lower: a share price decline or/and an EPS growth. According to Caterpillar's Q4 2016 earnings presentation, the company expects that it will record EPS of $2.3 in 2017. At the current share price, the resulting P/E ratio would equal to 42.81. It is much lower compared to the current value of 88.32, but it is still approximately two times higher compared to the P/E ratios of Deere & Company and Komatsu. At the current share price, Caterpillar would need EPS over $4, to push the P/E ratio back down, to the levels that are common for its industry.

CAT PE Ratio (<a href=

CAT PE Ratio (NYSE:TTM) data by YCharts

What holds Caterpillar above the water?

From the valuation point of view, Caterpillar's shares are significantly overvalued and a correction should be expected soon. But the stock market is often irrational and the emotions can push Caterpillar share price even higher, before it starts to fall. Caterpillar's impressive share price performance has been fueled by the revived commodity bull market and the long-lasting U.S. stock market bull. After Trump was elected, investors started to hope that some huge infrastructure investments will be realised and Caterpillar will profit from it tremendously. If the strong commodity prices persist and the U.S. stock market avoids any major correction, Caterpillar may remain overvalued for a prolonged period of time.

Shares of Caterpillar bottomed on January 25, 2016, at a share price of $57.91. From this moment, they have grown by more than 70%. This impressive growth coincides with the revival of a commodity bull market. Iron ore bottomed on December 15, 2015, gold and silver on December 17, zinc bottomed on January 12, 2016, copper on January 15, platinum on January 21, nickel and WTI on February 11. In the case of all of the abovementioned commodities, double digit gains followed. The biggest gains were reached by iron ore (126%), WTI (99%) and zinc (98%).

The chart below shows the correlations between Caterpillar share price, the abovementioned commodities and two major stock indices (the U.S. Dow Jones Industrial Average and the Chinese SSE Composite) over the last 3-, 2- and 1-year period. The data show, that there was a strong correlation between the Caterpillar share price and copper, iron ore, zinc, nickel and WTI prices, over all of the three time periods. Moreover, during the last twelve months, there has been also a strong positive correlation between Caterpillar and Dow Jones Industrial Average and between Caterpillar and SSE.

Source: own processing, using data of Stooq and Quandl

The chart below captures the dynamics of the correlations. It shows the 100-day moving correlations between Caterpillar share price and the commodities listed above. As can be seen, Caterpillar has a relatively stable strong positive correlation especially with iron ore, nickel, copper and zinc. The correlations with precious metals and oil are much more volatile.

Source: own processing, using data of Stooq and Quandl

The chart below shows that Caterpillar has a strong positive correlation with the Dow Jones Industrial Average and over the last 18 months, also with SSE Composite.

Source: own processing, using data of Stooq and Quandl

Conclusion

One year ago, I was bullish on Caterpillar. Today, the situation is quite different. Although I don't exclude the possibility that Caterpillar's share price will keep on growing for some more time, its shares are significantly overvalued and a correction is only a question of time. Only strong commodity and stock markets hold shares of Caterpillar at the current levels. Any stock or commodity market weakness can initiate a major decline of Caterpillar share price. And even if no weakness occurs, Caterpillar will need to deliver exceptional financial results to validate its current valuation. I see more downside than upside in the shares of Caterpillar right now.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.