Market Overview

How High And Long Can This CAT Jump?

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Caterpillar's (CAT) stock price touched an all-time high of $172.99 on Jan 16 and has drifted lower since.  This price action took place after an upgrade from JP Morgan a week ago.  The stock jumped 2% on Jan. 8, when JPM report came out. 
 
Shares of Caterpillar have already climbed almost 80% over the past 12 months while the S&P 500 advanced about 20% during the same period.  In fact, Caterpillar was one of the top five performing stocks of the Dow Jones Industrial Average (DJIA) in 2017.  Caterpillar, along with Boeing, have helped boost DJIA to record highs over the past several months. 
 
From some of the upgrade analysis you can tell how the investing community has lost almost all common sense perspective in this central banks fueled market rally.  For example, instead of top or bottom line growth potential, UBS bumped up CAT's target price by 16% a week before JPM noting the tax bill could provide around $750 million for share buybacks.  When has share buyback even become an element in stock recommendation? Does that suggest if Caterpillar decides to invest the extra cash for business, UBS would give it a downgrade?     
 
"10-Year Upcycle"

 
JPM at least came up with a stronger argument.  According to JPM, the primary driver of CAT shares "in the coming years" is the Republican tax reform bill.  Since then, several other investment houses came out with higher price targets for Caterpillar also citing GOP tax bill as the catalyst.      
 
JPM argues that the global economy as a whole has entered into a "10-year upcycle" in commodities. Production of iron, coal, copper, etc. is rising, and bringing prices along with it.  In JPM's estimate, we're currently entering only year two of this upcycle.  That means Caterpillar has nine more years to benefit from the "10-year upcycle".  
 
Party Like It's 2005

 
According to JPM, the construction industry could absorb as much as 233,000 annual unit sales of heavy mining equipment, matching peak sales at the top of the last upcycle in 2005. 
 
I'm not sure why investors should get all excited over the possibility of the entire construction industry equipment unit sales back to the 2005 levels?  Not to mention it is uncertain how much of the 233,000- unit-sales pie CAT would have?    
 
What's Really Going on at CAT?

 
Now let's take a look at what's happening at Caterpillar to actually warrant this exuberance. 
2016 was a five-year low point for Caterpillar.  Its sales were falling for four straight years.  The company suffered a 36% drop in earnings in fiscal 2016 citing weak end-user demand in most of the industries it serves, including construction, oil and gas, mining and rail. 
 
CAT%2BNet%2BIncome.png
 
 
Caterpillar managed to rebound in 2017.  In 3Q 2017, trailing-12-month sales increased 9% from their 2016 trough, and free cash flow grew 63%.  It is a moderate improvement considering the easy comp's to the 2016 low's, but enough to impress investors to think Caterpillar has delivered a successful turnaround. 
 
By the way, I forgot to mention federal agents raided Caterpillar headquarters last March as part of the government investigation into the company's alleged tax evasion by shifting corporate profits to a subsidiary in Switzerland.     
 
PE At 112, Really

 
Caterpillar's Price Earnings (PE) Ratio has gone from 8.81 in 2006 to currently 114, compared to around 26 for the average of S&P 500.  Normally, the PE of industrial manufacturers such as Caterpillar should have a PE in single digits to the mid-20's range.   
  
Remember the core business of Caterpillar is making industrial equipment such as tractors, which is a mature sector.  And CAT is not a sexy tech stock with tremendous growth potential justifying a high-flying PE multiple.  Even Facebook (FB) only has a PE of 35 which is only 30% of what Caterpillar commands.      
 
More Like 10-year Tightening Cycle

 
Furthermore, remember we are actually in the beginning of central banks' tightening cycle.  The US Fed helicopter is ahead of the monetary easing curve after the 2008 financial crisis, and again is ahead of the coming global tightening cycle.  Expect other central banks to eventually follow suit (it is safe to say within the next 10 years).   A business cycle typically lasts about 8-10 years.  The current business cycle began from the 2008 financial crash/monetary easing and has already pushed into uncharted territory.   I'm not sure how JPM could realistically model the "10-year upcycle" projection given the current lofty valuation on almost all asset classes and the increasingly high risk of war and recession. 

Disclosure: At the time of this writing, author and EconMatters do not have position in the aforementioned stocks.  Views and opinions are author's own.

The preceding article is from one of our external contributors. It does not represent the opinion of Benzinga and has not been edited.

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