Our steroidally challenged economy
The third in a 3-part series on the steroidization of our economy.
By Vitaliy N. Katsenelson, CFA
This presentation covers the main concepts discussed in the series and shows how we are positioning for this very different economy.
The stock market’s recent rally followed a typical, by-the-book, coming out of recession trajectory – it was cyclical. The stocks most sensitive to the economy appreciating the most.
Let me demonstrate what is priced into cyclical stocks by looking at Caterpillar (CAT) – your typical American blue chip industrial, cyclical stock – one that in theory should prosper during global economic recovery.
Third-quarter sales were down 44% from last year. China was its brightest spot as sales there dropped (only) 26%. The stock is around $60, more than double its low in March and not far from $85, its all-time high, reached in 2008 when global growth was its oyster. The company expects to earn around $2 this year (excluding recurring nonrecurring charges) and expects sales to grow in teens next year from this year’s base. But even if CAT were to earn $3 next year, investors are not paying for next year’s earnings, as they’d paying 20 times next year’s earnings.
This cyclical stock is not worth that; investors are paying for what happens beyond 2010.
To understand what happens past 2010, let’s see what is driving CAT’s next year’s earnings growth. Here is a quote directly from a CAT press release:
“[Global] Governments introduced more than $3.5 trillion in multi-year stimulus programs with most of the expected impact in the last half of 2009 and into 2010.”
If I owned CAT, the question I’d want to know the answer to is, what’s next after 2010?
Stimulus creates an appearance of stability and growth, but a lot of it is teetering on a very weak foundation of government intervention. Investors must distinguish between what is real and what is not; in this environment, investment success will not only depend on what stocks you own but also on the ones you don’t – stock selection is important.
The hopes that we’ll transition soon from government steroiding back to an economy running on its own are overoptimistic; there is just too much stimulus in the economy for that to happen. The detox process from the massive consumption of steroids will not be a smooth and painless experience.
This transition will be slow and rocky, as today’s stimulus wears off and we hit the wall in this economic marathon.
P.S. The four most dangerous words on Wall Street: “This time it’s different.” However, this time, this recession, is not the same, either; we are not suffering through your garden-variety corporate recession, it’s a consumer one. Consumers, two-thirds of the economy and its past growth engine, are now the economy’s weakest link: consumer debt-to-GDP is pushing 120%, double what it was in the 1980s. The financial system, though stabilizing, is hanging on the whims of one economic statistic: employment.
Over the last couple of weeks we have started seeing the first signs of a second (or third, I’m losing count) wave of layoffs. For instance, J&J, Electronic Arts, and Pfizer all announced they’ll lay off a large percentage of their workforce. Higher unemployment will trigger larger loan defaults, and then we may even have another round of bank problems.
Vitaliy N. Katsenelson, CFA, is a portfolio manager and director of research at Investment Management Associates in Denver. He is the author of "Active Value Investing: Making Money in Range-Bound Markets" (Wiley 2007). To receive Vitaliy's future articles by e-mail, click here.
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What does the country have to do with the price-to-earnings ratio of the S&P industrials? From here on in, everything.
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