As Goes the Economy, So Goes Caterpillar Stock

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In early 2018, slowing global economic growth concerns came to center stage. They’ve remained there ever since, dragging on stocks,  as U.S. economic growth has moderated, Europe economic growth has slowed, and China’s economic growth has deteriorated to decade lows. All of that has come against the backdrop of rising trade and geopolitical tensions.

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As those growth concerns have remained front and center, the shares of industrial giant Caterpillar (NYSE:CAT) have remained weak. In January 2018, CAT stock was trading for $170. Today, CAT stock price is  around $135.

The set-up of CAT stock is promising at this point. An economically sensitive stock is trading at a hugely discounted valuation because the economy is slowing. But if the economy picks up any sort of steam and then holds onto its momentum,  investors’ sentiment towards CAT stock will rapidly improve. At that point, strong multiple expansion will drive CAT stock price significantly higher.

But CAT stock has been in that situation for what seems like over a year. During the past year, Caterpillar stock has consistently failed to hold onto its gains, and CAT stock price hasn’t come anywhere close to touching its January 2018 highs.

That’s why, before buying CAT stock on weakness, investors should understand three very important things about this stock. Here are those three things.

Caterpillar Stock Is Cheap for a Reason

First, and foremost, Caterpillar stock is cheap for a reason. In other words, this stock isn’t a bargain. Instead, it is understandably cheap.

CAT stock is trading  at 11 times analysts’ average forward earnings estimate. That’s well below its average valuation  over the last five years of 18 times the consensus forward earnings estimate.   But that doesn’t mean that the stock is way undervalued relative to its historical norm.That’s actually not the case.

CAT is an economically sensitive stock, so when the economy slows and/or collapses, Caterpillar’s profits slow and/or collapse, too. That process unfolded in 2008 and 2009, when Caterpillar’s earnings per share were essentially chopped in half. Investors are always fearful of CAT undergoing a similar process again. Thus, when the economy slows, as it’s doing today, investors get really worried about Caterpillar’s future earnings. They stop believing that its profits are going to definitely rise for the next several years, and start pricing into Caterpillar stock some chance that the company’s profits will actually collapse.

That is what’s happening today. The economy is slowing. Investors are starting to price a potential decline of Caterpillar’s EPS over the next several years into CAT stock.

Thus, while CAT stock is cheap today, it’s cheap for a reason.

Caterpillar Stock Won’t Rebound Until Economic Conditions Materially Improve

The most likely scenario at this point is that the economy will slow, not get wiped out. As a result, Caterpillar’s profit growth will probably slow, not cease. If the most likely scenario does materialize, CAT stock should rebound from its current level.

But such a rebound won’t happen until the global economy stabilizes.

At the moment, the world’s economic data isn’t great. The U.S. labor market, while still strong, is slowing. U.S. consumer confidence is slipping. China’s economy is expanding at its slowest rate in nearly 30 years. The numbers coming in from Europe aren’t strong. The all-important yield curve has inverted, and many consider that a harbinger of a recession. Trade tensions are escalating.

In other words, there are negative signs everywhere suggesting that the world’s economic growth prospects are poor. As long as those yellow flags hang around, investors will continue to be concerned about Caterpillar’s profit growth trajectory. As long as those concerns persist, CAT stock will remain depressed.

Thus, before CAT stock rebounds tremendously, the macro economic picture needs to improve. Such improvement will likely come in the form of a trade deal, renewed China growth, a bounce-back in U.S. consumer confidence, and/or stronger European economic data.

When Things Do Improve, CAT Stock Price Will Jump Tremendously

Bulls are 100% right about one thing. When economic conditions do improve, the rebound of CAT stock will be huge.

Just look at what happened to CAT in 2008-2009. The economy went into a downturn. Caterpillar’s profits were wiped out. The multiple of CAT stock sank to multi-year lows. The stock got killed. Then, the economy started to rebound. CAT’s profit growth returned. The multiple expanded. The stock rose by a large amount. Between February 2009 and February 2011, CAT stock rose 500%, jumping from $20 to $100.

Of course, the economy is much better today than it was in 2008.  Consequently, whereas CAT stock dropped nearly 80% back then, it is down just 20% from its all-time highs today.

Naturally, the more muted selloff will result in a more muted rebound of CAT stock. But Caterpillar stock can still rebound tremendously.

Right now, analysts, on average,  predict the company’s  EPS will reach about $13  by fiscal 2021. Investors are having a tough time believing that EPS target is plausible, given the current macro headwinds. But, if a trade deal gets struck in 2019, global economic data improves, and Caterpillar’s growth trends similarly improve going into the end of the year, then investors will head into 2020 believing that the company’s EPS can reach $13 by fiscal 2021.

As a result, investors’ sentiment towards CAT stock will improve, and its valuation will normalize. The five-year average forward earnings multiple for Caterpillar stock is 18. A forward multiple of 18 on 2021 EPS of $13 implies a 2020 price target of over $230. Thus, between now and the end of 2020, CAT stock could rally more than 70%.

The Bottom Line on CAT Stock

If we aren’t on the verge of an economic downturn, and the economy does stabilize in 2019 and start to improve in 2020, then CAT stock is well-positioned for a huge rally over the next 12-plus months. But such a rally won’t happen until data supports the notion that the economy is improving.

Thus, when it comes to CAT stock, the best thing to do is wait and watch the data. If it gets better, buy CAT. If it gets worse, stay away from it.

As of this writing, Luke Lango did not hold a position in any of the aforementioned securities. 


Article printed from InvestorPlace Media, https://investorplace.com/2019/06/as-goes-the-economy-so-goes-caterpillar-stock/.

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