What Macro Tells Us About Caterpillar

About: Caterpillar Inc. (CAT)
by: Leo Nelissen

Caterpillar's stock price has completely ignored the most recent earnings beat and higher guidance revision.

This has a reason as leading economic indicators have started to decline since the end of 2018 resulting in lower stock price and sales expectations.

The stock is a strong buy once economic indicators start to bottom as a lot has already been priced in at this point.

Caterpillar (CAT) is not only one of the world's largest producers of heavy machinery, but also one of the most interesting macro stocks on the market. The stock has a phenomenal ability to provide traders with the option to track economic momentum. That's why I will show you in this article what we can expect from Caterpillar going forward after the stock has been through a ton of volatility since last year. So bear with me!

Source: Caterpillar

Macro Matters

First of all, it is important to remember a few things before I go into any depth. As well known as these numbers are, it still makes sense to mention them again. Caterpillar is well-known for its cyclical product portfolio ranging from mining equipment to excavators. More than half of the company's sales are generated in construction and resource industries. These industries are incredibly dependent on capital expenditures in cyclical industries. I have not yet mentioned the company's energy exposure because oil capex is able to diverge from the 'general' economic trend as late-cycle economies often see a spike in oil prices. That said, one could make the case that 100% of the company's product portfolio is dependent on economic expectations.

With that said, I just recently published my economic outlook article, which discussed a set of leading indicators. Leading indicators like the ISM manufacturing index tell us what we can expect in terms of 'hard' economic growth over the next 3-6 months. With regards to the ISM manufacturing index, a value above 50 indicates economic growth whereas a value below 50 indicates contraction. However, it does not end there. The trend matters more than the current ISM value. A 52 reading for example is much more positive shortly after the ISM index turns positive after a slump. A value of 52 within a larger downtrend is bad news because large traders tend to cut long exposure once growth starts to trend down above 50. Downtrends below 50 usually end up with funds going net short.

Anyhow, without further ado, let's look at the ISM manufacturing and regional manufacturing surveys. What we see is a steady decline since 2018 when economic growth peaked. I felt incredibly silly discussing a likely growth slowing trend back in Q4 of 2018 when growth was at multi-year highs and I took a lot of heat for it. But here we are: growth has declined to multi-year lows.

The ISM manufacturing index declined to 52.1 in May which is a decline of 0.7 points compared to April of this year. Yes, that still indicates economic expansion, but it's the trend that matters.

As a result, durable goods machinery orders year-on-year growth has declined to a mere 0.2%. As a comparison, more or less the entire third quarter of 2018 had growth rates of more than 6%. And speaking of 2018, the ISM index perfectly predicted these growth numbers as the ISM index was hovering around 60.0 back then.

Source: Author's Spreadsheets (Raw Data: St. Louis FED)

With that said, let's move over to the very core of the article and the reason you are reading this article: Caterpillar.

With everything I had said so far in the back of our head, it does make sense that the company reported first quarter earnings worth $2.94. This is once again expectations of $2.84 but only a growth rate of 4% after all prior quarters either showed double or triple-digit EPS growth. On top of the earnings beat, the company raised full year EPS guidance to the $12.06-$13.06 range from $11.75-$12.75. The result on the stock price: absolutely nothing.

The graph below shows both the ISM manufacturing index and the year-on-year performance of the Caterpillar stock price. The stock started to lose momentum in 2018 as soon as growth (ISM index) started to peak. That's the point where the risk/reward ratio starts to get worse and traders start to go overweight defensives as I mentioned in this article. Downtrends in growth territory cause net exposure to be cut which usually starts with cyclicals like Caterpillar.

Source: Author's Spreadsheets (Raw Data: ISM)

Need some more confirmation? The graph below shows both the ISM index and the ratio between industrial stocks (XLI) and the S&P 500.

Source: TradingView

And analysts are slowly waking up. The average Caterpillar price target has been cut from $180 in Q1 of 2018 to currently $148. Additionally, the average 2019 sales target has been cut from $57.9 billion in June of 2019 to currently less than $56.6 billion.

I know, at this point, I am probably getting some emails with regards to my bearishness and whether I expect Caterpillar to go bankrupt or not. Well, let me say, I don't think the company is going nowhere. Especially not bankrupt. I admire the company's product portfolio, excellent global sales footprint and with a current ratio of 1.40, I am not too worried about short-term liquidity.

That's why the stock is on my watchlist as a long. Even if the company remains at current prices, investors are pricing in an ISM decline to 50.0 over the next 3 months. In other words, if this happens, we still should not expect a total stock price implosion. It gets tricky once the ISM index goes below 50. Such a scenario could push the stock below key support towards $100.

Source: FINVIZ

However, if the ISM manufacturing index starts to bottom, and by bottoming I mean 2 or 3 higher ISM readings, I think we are looking at a tremendous buying opportunity. Just look what the stock did last time when the ISM index started to go from bottoming to growth acceleration (2016-2018). The stock went up from $60 to $160 without getting too expensive. Simply because earnings accelerated as well as you can see below.

Note that the stock is currently trading at 12.4x earnings and a forward PE of 10.3.

In other words, the situation we are in is as follows: Caterpillar's stock price has been under fire since 2018. This is the result of peaking and slowing leading indicators that caused investors to more or less ignore higher EPS guidance and higher than expected earnings. The company's stock price targets and sales expectations continue to be lowered as analysts realize that something is wrong.

Nonetheless, the stock has priced in a lot of negativity. The only thing that could ruin a bottom at this point is an ISM value below 50. At that point, I expect the stock to break down to at least $100.

However, if the ISM index starts to bottom here, I am sure we are looking at a great stock. Even if you miss the perfect entry, it makes sense to wait for confirmation. Especially because the stock tends to go up for many quarters if growth starts to accelerate indeed. We also could get some help from strengthening commodities during the next cycle as I discussed in this article.

So, all things considered, I am staying on the sidelines for now. The stock is on my watchlist as a buy if we get an economic bottom. In 2016, I missed a good buying opportunity, and I won't let that happen again.

Stay tuned!

Thank you very much for reading my article. Feel free to click on the "Like" button and don't forget to share your opinion in the comment section down below!

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.

Additional disclosure: This article serves the sole purpose of adding value to the research process. Always take care of your own risk management and asset allocation.