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Overvalued Caterpillar signals downtrend

The stock of earth moving equipment manufacturer Caterpillar Inc (NYSE: CAT) recorded a new 12-month high of $119.80 in the last week of August. Of late, the company has been performing very well.

Caterpillar reported robust non-GAAP earnings of $1.49 per share on revenues of $11.331 billion for fiscal 2017 second-quarter. The company has also received a large order from the US government and the stock also received an analyst upgrade. That took the price to a new yearly high.

However, we expect a short-term correction in the stock due to reasons discussed below.

Recently, the US Department of Defense offered a $663.6 million contract to the Peoria, Illinois-based Caterpillar for the supply of commercial construction equipments. Caterpillar outbid three other companies to receive the five-year contract. The news of receipt of a large government contract sent the stock soaring. However, we believe that there is not much of an upside left in the stock as of now.

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In fiscal 2016, Caterpillar reported construction equipment sales of $3.754 billion in the Asia/Pacific region. That accounted for nearly 10.5% of the overall revenues of $35.77 billion in equipment sales. Considering the pace of construction activity in China, it can be inferred that most of the revenue was generated from that country. Even though, China made up only about 10% of total sales, still, it is considerable as the construction equipment sector was the only one to post a y-o-y growth (13%) in fiscal 2016. Thus, most of the appreciation in the share price was a result of good performance in that sector.

Construction spending in China is on a long-term decline, as the country shifts from heavy industries to a service based economy. In developed countries, service sector constitutes between 70% and 80% of total economy. In China, the service sector accounts for only about 50% of the total economy. Thus, a shift to a service oriented economy would result in approximately 25% decrease in construction spending and fixed asset investments. That would certainly affect the prospects of Caterpillar, which derives about 25% of its total revenue from China and global mining.

Caterpillar also generated about 16% or $5.73 billion of its total revenue from the mining sector. However, the global mining boom is ending as indicated by the reduction in the capital expenditure of many multinational companies.

Finally, the stock is trading at a forward price to earnings ratio of about 24.5, versus five-year average of 19.6. The price to book ratio is 5x, whereas the historic average is only3.2. The price to book ratio of S&P500 is 3x. Thus, fundamentally, the stock is overvalued and so a price correction can be expected.

Recently BMO Capital Markets has reiterated its buy rating on Caterpillar, with a price target of $130. Since that is a one year price target, it would be wise to buy the dips than at the current expensive valuations.

Technically, the momentum indicator has made a negative divergence with the price. Additionally, the Williams Percentage Range oscillator is in the overbought region. The stock is also facing resistance at 118.50. Thus, we anticipate a downtrend to begin in the week ahead.

Caterpillar Stock Price: September 12th 2017

Caterpillar Stock Price: September 12th 2017

A put option looks well suited to trade the anticipated downtrend in the stock. We would like to trade the downtrend as long as the US binary broker offers an option contract valid for a week. Additionally, the stock should be trading near $118 in the equity market.

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