Just as it is easier to draw straight lines than to think in
nonlinear terms, it is simpler to buy stocks that have gone up
a lot over the previous decade than to remain committed to the
ones that have done nothing. However, linearity is for suckers.
Success in investing comes from being able to see not what is
in front of you but what is lurking just around the corner.
Take heavy-equipment makers Caterpillar, Deere & Co. and
Joy Global. It is easy to love these deeply cyclical companies,
which have benefited from the run-up in commodity prices over
the past decade. Their stocks are up manyfold over that period,
and for good reason: Their sales and earnings have tripled or
quadrupled during that time.
The story only gets better. Earnings for Caterpillar, Deere
and Joy Global are expected to continue to grow in the double
digits well into this decade. In theory, these American icons
should be a value investors paradise because, despite
their past success and expectations of their future wonderful
growth, they are trading at low-double-digit P/Es.
But before you run out and spend your hard-earned money on
these darlings, lets see what might be around the corner.
The past few years were characterized by fairly robust growth
of the global economy. Part of this was simply a recovery from
the 2008 crisis; however, a significant part was spurred by
Lets pause for a second and think about that. The 2008
global recession took place because of substantial borrowing
from underreserved financial institutions that went into global
malinvestment in fixed assets. That put a hurricanelike
tailwind in the sails of deeply cyclical stocks. For eight
years, until 2008, their sales and earnings grew as if Google
were their middle names. Investors stopped treating them like
cyclical stocks; they became deep seculars.
The global fixed-asset bubble burst painfully in 2008, and
the deeply cyclical stock story should have been over. After
all, if you build too many things that will last you decades,
you will not need to make more of them for a long time, and
thus you will need a lot fewer earthmovers from Caterpillar.
This would have been a rational expectation and it would
have been wrong. The sales and profitability of Cat, Deere and
Joy Global have already surpassed the levels they reached
before the 2008 crisis.
Because of massive global government stimulus
turbocharged by Chinas 12 percent-of-GDP mother of all
stimuli, which was further amplified by off-the-charts leverage
the asset bubble has been reinflated over the past
couple of years. The stimulus came at a significant cost: the
increased leveraging of governments. Last year showed that
there is an upper limit to how much developed-country
governments can borrow, unless they are willing to borrow at
double or triple their current rates.
We are very likely entering a third leg of global
deleveraging. The first two were by consumers and corporations,
and to a large degree took place at the expense of the
governments that took over their debts. Now we are entering the
most painful stage: government deleveraging, which will be
destimulating to the global economy and cause a monstrous
decline in fixed-asset investment.
Today investing in deeply cyclical stocks is not unlike a
game of musical chairs. If you own these stocks, you are
coining money while the music is playing. We know what will
happen when the music stops: These stocks will plummet.
Caterpillar, Deere and Joy Global benefit from operational
leverage. A large portion of their costs is fixed, and as their
sales increase, their margins do too. Their earnings are high
because their profit margins are at an all-time high, but once
the global economy slows down and demand evaporates, sales will
decline. Their operational leverage will start working against
them because costs will not decline as fast as sales, and
margins will do what theyve always done: Theyll
revert toward the mean and in this case collapse. The
companies earnings power will be completely reset and
will not resemble anything even close to what it is today.
Suddenly, stocks that looked so cheap will show their true
Of course, its difficult to know when the music will
stop tomorrow, six months from now or in two years.
Bubbles dont follow the timetables established by their
prognosticators, even when their collapse is being predicted.
However, the risk-reward of owning these deeply cyclical stocks
has clearly shifted into unfavorable territory. If you think
you possess perfect pitch and will hear the music stop and be
able to grab a chair before everyone else, dont kid
yourself. The dot-com investors of the 90s thought they
could, and very few of them got to sit down gracefully.
Vitaliy Katsenelson (email@example.com) is
CIO at Investment Management Associates in Denver and author of
The Little Book of Sideways