Caterpillar: A Buy on Further Weakness?

I think the market will continue to correct. But while several indicators and charts for Caterpillar (CAT) and the market are flashing warning signals, the charts aren’t definitely saying sell, yet. Longer-term, the options markets and at least one analyst seem to be bullish on CAT.

By Donald Johnson -- So I think that if CAT falls to around $25 or $27, it would be a good long-term buy with close stops. It closed Friday at $31.34.

Some of the mixed indicators for CAT are discussed below.

As you can see in these two-month charts for CAT, its peers (DE, JOYG, BUCY, CMI) and the overall market, they all are trading above the 50-day moving average, which is bullish.

This link is to a gallery of hourly, daily, weekly and point and figure CAT charts. They present a mixed picture.

The daily chart still shows CAT above the 50-dma, but the daily (moving average convergence divergence) MACD is flashing a sell signal. And the cash money flow below the daily chart is showing more sales than buys, which is bearish.

Scroll down to the weekly chart.

It shows CAT trading below the 50-dma. The relative strength chart just below (cat:$spx) (spx-S&P 500) has turned bearish. The PPO just above the weekly price chart is another oscillator that is very similar to the MACD on the daily chart. It still is positive but trending lower.

Here’s the big sell signal. Scroll down to the point and figure chart, which tracks the supply and demand for the stock regardless of time. CAT has just broken out on the sell side (see the little red “o”). The bearish price objective is $30 vs. Friday’s close of $34.31.

$30 doesn’t look so bad until you look where the stock’s been since last fall, touching $22. Point and figure charts are only guides, not forecasts. They are correct some 70% of the time. Stocks often reverse before reaching price objectives, and they often over shoot their objectives, sometimes by a lot.

Now look at CAT’s beta. If a stock moves perfectly with the S&P, the Beta= 1.0. Cat’s beta is 1.67, which means that when the market drops, CAT drops 1.67 times as much percentage wise.

Look at the PE and PEG ratios on the same screen. The trailing price earnings ratio is 8.42 even though earnings are declining. Even more ridiculous, the forward PE is 22.28, which assumes earnings will grow 22% next year. The five-year peg ratio (PE/5-year expected growth) is a hugely expensive 4.31. I never buy PEGs over 2.0 and generally buy under 1.5. But PEs really mean nothing these days because who knows what earnings will do? Nobody.

The stock is selling for a very cheap 0.44 times sales. And that may keep the stock up a bit despite a sharp decline in sales. This company is just too good to trade at that price for long, assuming the economy will recover in three or five years.

CAT was profitable in the first quarter. It’s operating cash flow was positive but its levered free cash flow was negative. It has $2 billion in cash and $34 billion in long-term debt. It was able to do a refinancing at an elevated cost back in September, and it should be able to roll over its debt unless credit markets freeze when it needs them.

CAT’s dividend payout rate is a reasonable 40%. Unless earnings fall below $1.68 a share, the dividend should be ok, but that’s a huge “if.“

One way to see what the smart money is thinking is to look at the options market. Looking at the call options that expire in Jan 2011, the CAT Jan 11 $35 strike calls are saying the stock will be over $40 at expiration. The put options say bears think the stock will close at about $27 or lower. The Jan ‘11 35 calls have an open interest of about 2,143 contracts, and the Jan ‘11 35 puts have an open interest of 1,524 contracts. Each contract is for 100 shares.

To me, this means options traders are slightly more bullish on CAT than bearish long term. Near term, however the options market is bearish on CAT. CAT’s put to call ratio is at a bearish 1.4. That means 1.4 puts are being traded for every call contract. Contrarians say a high P/C ratio is bullish because it shows a stock or market is over sold. I'm not inclined to be a contrarian here.

Morningstar.com says CAT’s estimated fair value is $51 with medium uncertainty. It says consider buying at $35.70 and consider selling at $71.40. Pretty bullish.

CAT’s historical volatility over the last year has been 62% and over the last two years 48%. Implied volatility suggests that CAT will trade over a 60% range between now and Jan. 21, 2011. Historical and implied volatility do a lousy job of forecasting volatility, however.

What this says is that because CAT’s Jan ‘11 implied volatility is slightly below its historical volatility, the Jan. 11 calls (LEAPs) are on the cheap side, assuming you are a bull on the economy and the stock.

Near term, I’m bearish. Some are bullish on the market and CAT for the next 18 months or so, but if the Barron’s warning that bear markets can last 13 to 16 years proves out this time, all bets are off.

Links:

• Must read: "Do be wary of green shoots" (Barron’s)
• Bloggers discuss CAT at Seeking Alpha
• "Is it safe? Caterpillar gets ground down" (The Street.com)

SOURCE: http://seekingalpha.com/article/139533-caterpillar-a-buy-on-further-weakness