Economic Old Age, Part 4: The Mother Of All High Water Marks

Caterpillar's management committed an unpardonable sin during the company's Q1 conference call. It was in the nature of admitting that beanstalks do not grow to the sky.

As it happened, CAT had posted another "blow-out" quarter by the lights of the headline reading algos. The instant this "beat" crossed the tape, CAT's already hideously over-valued shares jumped by another 2%---only to get monkey-hammered when its CFO, Brad Halverson, uttered three words with respect to Q1 results that are about as welcome on Wall Street as a skunk at a garden party.

Them numbers are the "high water mark", said he (Halverson).

That will cost you $7 billion in market cap, said they (the robo-machines and day traders).

Needless to say, one of the great evils of monetary central planning is that it has turned Wall Street into a petulant, demanding, entitled horde of gamblers who believe, in fact, that stock prices do grow to the sky; and that they are entitled to "buy" signals always, truthful bad news never.

For instance, has any management team ever focussed on its share count shrinkage rate and acknowledged that by borrowing money or diverting cash flow to fund buybacks they were creating risks, to say nothing of peril, for future performance?

Has any CEO pumping his or her latest mega-M&A deal ever acknowledged that the ballyhooed "synergy" savings could just as easily reduce sales, impair operating performance or retard future product innovation as increase margins and earnings?

And most especially, what company has ever admitted that despite management's diligent efforts to improve and excel that in the end it's a creature of the business cycle? And that there is no business cycle in recorded history that has not expired for one reason or another?

That's why we believe CAT's accidental truth telling is so emblematic of the current moment. On a statistical basis, the current cycle has turned octogenarian; and on a fundamentals basis, it's been living on borrowed time and borrowed money for years.

Among other things, this means that the ballyhooed double-digit gain in Q1 earnings should be viewed through downright squinty eyes. As in the illustrative case of McDonald's results, where the 22% advertised gain was actually a goose-egg in economic terms (see Part 2), the overwhelming share of the Q1 gains have been due to one-time boosts from the corporate rate cut, share buy-backs and currency.

The first two are obvious with effective tax rates running 10-20 percentage points below last year, and the S&P 500 share count down by 2-3%. But the impact of FX on S&P earnings is almost as dramatic---given that more than 50% of profits are attributable to foreign operations.

To wit, in Q3 of 2014, the dollar's traded weighted exchange rate hit a 20-year low at just under 103 as per the chart below. At the same time, reported LTM earnings for the S&P 500 companies hit a post-recession high of $106 per share in part due to a heavy FX gains from the punk dollar.

Then everything took an about face. As is evident in the chart below, the dollar strengthened robustly during the next three years, rising by more than 25% to 129 by the start of Q1 2017.

During the interim, oil and commodity prices and profits also fell sharply---meaning that in combination with the rising dollar, S&P earnings took it on the chin. By mid-2016, LTM earnings were down to $87 per share or by 18%.

Next came a march back uphill by the short-run drivers of S&P 500 profits. The global commodities and trade cycle rebounded under the force of a giant credit impulse emanating from the Red Ponzi as Beijing goosed its debt mountain one more time in preparation for Xi Jinping's coronation as ruler for life last October.

That substantially boosted S&P profits in the materials and industrials sectors. At the same time, the dollar took a drubbing from its early January 2017 peak. It plunged by 10% to a low of 115 by the end of January 2018, thereby further adding to reported earnings via FX translation gains.

Accordingly, S&P 500 earnings appear to be hitting $117 per share on an March 2018 LTM basis. That's up 17% from one year-ago and 36% from the mid-2016 low.

But it's also a case of high water marks in spades. The dollar is already reversing sharply and with US bond yields rising and the phony "synchronous growth" story collapsing abroad, the greenback has nowhere to go but up. And even if the dollar's current strong rebound stalls out, it has little prospect of another 10% plunge on a quarter-over-quarter basis as occurred in Q1 this year.

More importantly, the round-trip of S&P earnings over the past four years amounts to a mere 2.4% per annum gain, and that's no aberration, either.

On the more than off-chance that Caterpillar's CFO was clairvoyant last week and Q1 2018 also turns out to be the cyclical "high water mark" for the broad market, S&P 500 earnings will have grown at a mere 3.0% annual rate for the entire decade since the pre-crisis high of $85 per share way back in June 2007.

Stated differently, the business cycle is now 42 months older than it was at the September 2014 interim high; global and domestic GDP growth is again slowing as the Red Ponzi struggles to avoid capsizing under its massive debt; and profit margins are already rolling over on an aggregate basis.

So forget the paint-by-the-headlines deltas. In truth, Q1 2018 is actually a crucial moment to examine the fundamentals of a business and profits cycle running up against statistical old age.

As it happens, the ebb and flow of CAT's financial results over the past decade closely track the broader market's journey to its present high water mark, albeit in slightly more dramatic and cyclically amplified form.

Needless to say, everything starts with the explosion of global central bank balance sheets from $2 trillion to $22 trillion over the past two-decades. That unprecedented 11X increase in high-powered fiat credit enabled an even greater eruption of global debt, and debt-driven GDP expansion.

During the two decades beginning in 1994, when China depreciated its currency by 60% and Greenspan opened-up the spigots at the Fed while capitulating to the bond market's hissy fit, and ending at the 2014 interim peak, global debt outstanding grew by the staggering sum of $185 trillion. That represented a sizzling 9.0% per annum rate of gain.

This did cause global GDP to also expand smartly--rising from $28 trillion to $78 trillion. Yet this represented a substantially more modest 5.3% growth rate, meaning that the planet's leverage ratio took a startling leap higher.

To wit, global debt to income soared from 1.45X in 1994, which represented the historic golden mean for economy-wide leverage ratios, to 2.90X by 2014---- and has continued to drift higher ever since.

It goes without saying that cheap, ample debt and robust GDP growth is a combination made in heaven from the point of view of the CapEx industry supplier base.

Heavy equipment was needed to rip metals and fuel from the earth's subsurface, transport it across the globe, erect new conversion capacity and infrastructure, construct new manufacturing and distribution facilities and accommodate the resulting gains in income with a vast expansion of the commercial and residential building stock.

Not surprisingly, global CapEx had a golden age, nearly quintupling during the period. Yet it did peak in 2012-13, and there is an undeniable reason why.


In a word, that's when the Red Ponzi's massive post-recession credit impulse reached a fever pitch, thereby driving global demand for CapEx and especially CAT's big yellow machines to off-the-charts historic highs.

However, when Beijing threw on the credit brakes shortly thereafter to cool down the resulting madcap digging, building, constructing, investing and speculating spree, activity rates fell sharply----only to trigger a new cycle of credit expansion and global demand, which peaked in early 2014.

The next retrenchment in 2015 and 2016 proved to be especially intolerable for the Red Suzerains of Beijing. That's because it threatened to literally spoil the party at the 19th Party Congress (held every 5 years) in October 2017 and Mr. Xi's planned ascension to the role of Supreme Leader with more power than any communist oligarch since Mao Zedong.

It was the subsequent surge in China's credit impulse and domestic investment and production that reignited global commodity demand and prices, as well as worldwide industrial production and trade during the second half of 2016 and through 2017.

That became known as "synchronized global growth" on Wall Street and was the rocket fuel that propelled the stock market to its January 2018 peak and helped earnings to rebound as outlined above.

But it was not the beginning of a forever pulse of global expansion; it was merely an interlude that served it purposes in Beijing, and is now being rapidly reversed. The plunging business sentiment indicators in Germany---which on the margin lives or dies on Chinese demand for its capital goods and luxury autos---is stark testimony to this truth.

Image result for images of china's credit impulse

Needless to say, as goes the Red Ponzi, so go the big yellow machines.

CAT's sales peaked at $66.3 billion in the June 2012 LTM period, as did its net income at $6 billion. Thereafter it was a long slog downhill as the historic and unrepeatable Chinese investment super-boom after the global financial crisis cooled from its 2012 peak.

Given CAT's extended inventory chain through its independent global dealer network, its own shipments fell for four straight years---with sales reaching a bottom during the September 2016 LTM period at $40 billion. This volume collapse, in turn, meant severe margin compression in what is a highly cyclical business with enormous fixed costs.

Accordingly, net income plunged by 83% to just $1 billion during the September 2016 LTM period.

But here's the thing. China 2016-2017 coronation credit caper did finally put a bottom under the global CapEx market. Consequently, CAT's dealers began restocking inventories, thereby goosing its reported sales and operating margins during the past six quarters.

And that, in turn, caused the Wall Street headline reading algos to get extremely frisky----if not go full retard lunatic. Between the early 2016 bottom and the January 2018 peak, CAT's stock soared from $60 per share to $170, representing a $65 billion surge in market cap.

Needless to say, the Red Ponzi was not about to repeat its 2008-2012 economic pyrotechnics, but the algos and so-called sell-side analysts had no trouble espying a return to $66 billion of sales and $6 billion of net income.

Alas, the high water mark is in. But sales have retraced only 31% of their 2012 peak and net income has recovered just 24% of its lost ground.
CAT Revenue (TTM) Chart

Needless to say, therein lies the moral of the story.

During the high water quarter just ended, CAT's LTM net income and operating free cash flow posted at $2.2 billion and $2.5 billion, respectively. That translates to valuation multiples of 46X and 40X respectively, at the January 2018 peak, and only slightly lower at its present share price of $144 (38X and 34X, respectively).

No one on the free market and in their right mind, of course, would pay such ridiculously high multiples for a violently cyclical business that has reached it high water mark.

Then again, the Wall Street casino is neither a free market nor are the speculators and robo-machines domiciled there in their right minds.

The evidence for the latter is in the charts below. During the last four years CAT's operating free cash flow has plunged by 58%---from $6 billion to just $2.5 billion during the just completed "blow-out" period.

At the same time, its market cap had risen by $40 billion or 67% at the January 26th high earlier this year, and is still up by 40%.

There is only one way that down become up, of course, and that is through humungous multiple expansion.

In fact, CAT's free cash flow multiple tripled from it historic 11-12X to nearly 34X at the present time.

And that happened even as it came off the aberrant Red Ponzi high of 2012 and drifted toward its current, dramatically more modest high water mark.

CAT Price to Free Cash Flow (TTM) Chart

Is CAT the only Q1 "beat" that actually has its nose up against the glass?

Stay tuned. We think the casino will soon be desperately hoping that current higher water marks are not a precursor for another cyclical of 2008-2009 style cliff-diving.



David Stockman's Contra Corner is the only place where mainstream delusions and cant about the Warfare State, the Bailout State, Bubble Finance and Beltway Banditry are ripped, refuted and rebuked. Subscribe now to receive David Stockman’s latest posts by email each day as well as his model portfolio, Lee Adler’s Daily Data Dive and David’s personally curated insights and analysis from leading contrarian thinkers.