The Central Bank induced misallocation of investment capital has reached new heights. The about $14 trillion in negative yielding government bonds has caused a reversal in junk bonds starting in February even as default rates have increased. After 5 quarters of declining year over year profits for firms in the S&P 500, analysts are predicting a return to growth. This would imply the economy skipped the downturn in the business cycle even as it is as leveraged as it was at the peak of the previous two cycles.
Investors were piling into safety dividend stock like Con Ed and McCormick earlier in the summer as a replacement for bonds in an uncertain growth environment. Even as GDP has shown the first half growth to be 1%, investors don’t care. They have begun to rotate into more risky cyclical stocks. Deere is near its 52 week high even after reporting double digit sales declines.
The interesting thing about Caterpillar Inc. (NYSE:CAT) is it has benefited from the more towards dividend stocks and the move towards cyclicals. Finally, it has also benefited from the rally in oil E&P stocks as oil has rebounded to $47 per barrel.
The reason why I am reviewing the investor money flow is because it explains why Caterpillar is at its 52 week high. As I stated in the introduction, the reason for this entire situation being in place is because central banks forcing investors to take more risks to get adequate returns. Money managers can’t go into cash because of restrictions. It’s a widely held belief that stocks are the only game in town. This is a systemically risky situation because you have a stock market held by “weak hands” who don’t believe in the fundamentals of the businesses they hold.
Caterpillar is a great example of a stock that has to be held by weak hands. It is a company the central bankers have propped up with their dovish policies. It is a company trading at a 2016 P/E of 30.5 even as it has declining earnings with no sign of a rebound. As you can see from the chart of the most recent sales reported, Caterpillar has extended its year over year decline in retail sales to 44 months, reporting its second worst sales results of this period. The 3 month rolling average decline in sales went from -12% to -19%. After this poor result, the stock didn’t blink an eye and maintained its 52 week high level.
As you can see from the chart below, not one of Caterpillar’s regions improved. North American sales fell 20% compared to 12% 3 months prior. Asia pacific sales were down 7%, which was the same as 3 months ago. Latin America fell 43% year over year compared to a 38% decline. Europe, Middle East, and Africa fell 13% compared to a 4% decline.
Caterpillar stock has rebounded with the anticipation of an improvement in 2017 even though the company doesn’t have visibility that far into the future. I have visibility into the future of the business cycle and it does not look like 2017 will be a recovery year. Of course, I don’t have a crystal ball, but the credit cycle is pointing towards further weakness.
As you can see from the chart below, C&I loan delinquencies have increased past the point they were at when the previous two recessions began. I think the best cycles to compare our current one to are the previous two because they represent the “bubble era” we are in. There have always been bubbles in assets, but Fed induced bubbles are bigger. This bubble is bigger than the previous too because it encompasses bonds, stocks, and real estate.
Charge offs on C&I loans are lagging behind delinquencies. They are showing we are between a quarter and over a year away from a recession. Whether we are in a recession or will reach one in late 2017 doesn’t matter much to Caterpillar because investors have driven it to its 52 week high on the basis we are at the beginning of the benign part of the cycle, when we are heading into to stress part of the cycle.
While the C&I cycle has shown to be headed into the stress cycle, we need confirmation, this isn’t a mid-cycle slowdown which would make it a head fake. As you can see from the first chart below, the investment grade gross leverage is higher than it was at the peak in 2008 and slightly lower than the peak in 2003. The chart on the right shows U.S. corporate debt as a percentage of GDP. It is higher than the peak in 2001 and at the peak in 2008. Both charts show the economy is not in a mid-cycle slowdown. It is in a late cycle slowdown, which will necessarily lead to a recession.
Recessions lead to a decline in energy demand and a weakening construction market, which is obviously bad for Caterpillar. The current slowdown is making up for the bubble-level demand from China created by its stimulus program. When a recession hits, we will see declines in retail sales like we saw in 2008. Therefore, Caterpillar’s rally is a head fake and should be sold.
Caterpillar stock has risen because of the situation created by central banks. No one would argue Caterpillar’s business is doing well. The only point a bulls can make is 2017 will be a better year. It would need to show significant growth to justify the high valuation. However, based on the credit cycle and the leverage in the economy, the odds are much higher that we are headed for the stress part of the cycle than the benign part of the cycle. This would mean Caterpillar’s rally is too early in the cycle. It needs to retrace its gains and hope for a recovery in 2018. I would stay away from Caterpillar stock at its current price.