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 investor’s paradise because, despite their past success and expectations of their future wonderful growth, they are trading at low-double-digit  P/Es. Cheap!

But before you run out and spend your hard-earned money on these darlings, let’s 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 global stimulus.

Let’s 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.

Continue reading it on Institutional Investor website…

Vitaliy N. Katsenelson, CFA, is Chief Investment Officer at Investment Management Associates in Denver, Colo.  He is the author of The Little Book of Sideways Markets (Wiley, December 2010).  To receive Vitaliy’s future articles by email, click here or read his articles here.

Here is what management said about China: “Fixed asset investment in May was 38 percent above a year earlier. Our dealers reported significantly higher deliveries of machines in June of this year than a year ago.” So the company is doing less bad as it expected because China is doing well. But we know that all of Chinese growth was driven by government consumption and tremendous liquidity growth. China’s largest consumers – the US and Europe – are struggling. It’s exports are down 21% in June, while its economy posted almost 8% growth and money supply is up 28.5% in June.

I know I sound like a broken record. Growth that is completely predicated on government spending is not sustainable, even if it is taking place in China. I don’t know when and what will cause that growth to seize (we didn’t know what would cause housing bubble to bust in the US either, but we knew there was a bubble). But when the growth stops, it could get very ugly and the only bright spot in CAT’s picture will get a lot darker.

Let me tell you when I’ll buy “stuff” stocks (if ever do buy them because I’ve never really cared for the cyclicality of their business). It’s when everyone stops telling me how cheap they are and that they are “buys.”

These stocks are very similar to housing stocks two years ago: housing stocks were down 50% and looked cheap. Value managers bought just to see their stocks get cut in half again and again.

One needs to sub-normalize earnings in this environment for all stocks, but “stuff” stocks need to see their earnings to be “sub-sub-sub-sub normalized.”  I’ve said it before, but it is worth repeating: the global economy just started its journey of going into a recession; demand for “stuff” will drop off the cliff most likely to a lot greater degree than anyone imagines.

I hear from my friends in Russia that the construction business that was booming only in September is dead. Like deader than dead.  It doesn’t matter if projects were finished or not, investors took their money and ran.  Russia may appear like a special case since its prosperity is directly linked to commodity prices, but the slowdown is happening in the rest of the developing world like China and India… and the list goes on.   

Stuff stocks are likely to bottom when they’ll look expensive – their “E’s” will be low or negative.  Also, consumers were not the only ones that over-consumed “stuff.” Emerging markets over-consumed earthmovers, tractors and factories. They still have huge overcapacity at a time when the global economy is slowing down.

Have a very happy and safe Thanksgiving!

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First, I am likely saying what people don’t want to hear; and second, because the message goes contrary to common opinion. So I am probably right about what I am about to say, as I am getting this tingly “don’t shoot the messenger, please” feeling while I am typing this: The global slowdown (and the key word here is ‘global’) is just starting and will last longer than most expect.

Until just a few months ago, the slowdown was taking place in the developed world: the U.S. and Europe. The developing world (China, India, Russia and Latin America) appeared to be marching to a different economic drummer. Those countries appeared be insulated from their biggest customers’ economic problems in the developed world. Suddenly in September, developing economies were not tone deaf anymore and started to march to the beat of the developed world’s drum and their economies joined up with the rest of the developed world and embarked on the decline.

Developing economies had an incredible decade of growth, but this growth is behind them, not in front of them, at least for awhile. An unstoppable growth train, mighty China, is derailing. The Chinese purchasing managers’ index fell from 47.7 points to 45.2 points in October, the steepest monthly fall and the lowest point since the index was started in 2004. Meanwhile, a government-backed survey of manufacturers dropped 6.6 points to 44.6 in October, also a record fall.

How much trust would I put in these numbers? Not very much as they are reported by a communist government, in a country where the expression “don’t shoot the messenger” has a different and more literal meaning. Anecdotal evidence from Chinese companies or companies doing business in China bears a lot more weight than government statistics that will likely lag reality by months (if not longer).

Here is some anecdotal evidence pointing to the actual severity of a slowdown. Unsold car inventories hit a four-year high, producers are defaulting on commodity orders as the demand for their products is not materializing; commercial and residential markets began to resemble their counterparts on the coasts in the U.S.; airlines started losing money as global travel declined; and the list goes on and on.

The longer a boom lasts, the deeper and wider it morphs into the economic system, and the more dire the consequences of its fallout. Take the U.S. housing and credit bust. It is not just limited to houses and subprime mortgages. It spilled into private student lending, completely shutting down that market. Prime and super-prime borrowers, once showered with money as if it were their birthday every day of the year, are unexpectedly getting their credit card limits lowered, according to a Federal Reserve survey of prime borrowers.

Since developing economies experienced a very significant boom that lasted a lot longer than most expected, the fallout will likely be deeper and wider than most expect. We are only in the beginning stages of the global slowdown. Being in the U.S., it feels as if it has lasted forever, but the global slowdown is just in the early stages in the developing world.

The global economy will not stabilize until developing economies do, and their destabilization journey has just started. Investors need to normalize, actually sub-normalize as one of my readers puts it, earnings of companies that have benefited tremendously from the global boom. I call them “stuff” stocks: materials, industrials and energy stocks. Though many of them look cheap based on trailing earnings, in many cases those earnings are an aberration. They were inflated by tremendous growth in the developing world and won’t be revisited for a long time.

Stuff stocks look cheap today just as the housing stocks looked cheap in 2005, Toll Brothers for instance was “only” trading at eight times earnings in 2005, but the cheapness was deceiving as the $4.76 of earnings it made in 2005 turned into a $1.55 loss in 2008. Many respected value investors jumped into housing stocks after they got halved in 2006, just to see them get halved again and again. Don’t make a similar mistake with “stuff” stocks.

Let’s take Caterpillar (CAT) for instance. More than 60% of its sales come from outside of the U.S., and its revenues almost doubled, and earnings tripled, over last four years. It sports a price-earnings ratio of only eight times 2009 already lowered earnings and the stock is down 50% since May. This has got to be a value investor’s paradise kind of stock, right? Maybe not.

CAT’s earthmovers are similar to houses, not just because they are about the same size and cost as much, but because, like houses, earthmovers are very durable and have very long lives. Also similar to the housing sector, CAT’s past sales compete with its future sales. The sum of CAT’s revenues from the four years between 2004 and 2008 exceeds the sum of the revenues CAT generated in the previous eight years from 1997 to 2004.

As I discussed above and in a previous article, developing economies in recession don’t just build less stuff, they build a lot less stuff. They are likely to be drowning in overcapacity since until just two months ago their economies were geared for growth, not decline.

Thus, CAT’s normalized 2009-2010 earnings are not likely to be around $5, as Wall Street expects today, but closer to around $2 or $3, or CAT’s earnings circa 2004 before its sales went on a tear. At $40, CAT is not as cheap as it appears.

Not all stuff stocks are created equal. Some make products that are a lot less durable in nature so that their past sales do not cannibalize present and future sales. For instance, Mine Safety Appliance is a stuff stock but it manufactures hard hats, working clothes and respirators–products that are not as durable as backhoes or homes. It also sells as much to firefighters as mine workers. Earnings need not be normalized so severely since the products that Mine Safety sells are replaced much more frequently than those of Caterpillar or Toll Brothers. This does not mean that I’m running out to buy Mine Safety since demand for these products decline during a global recession, even though past sales will not compete with future sales to the same degree [though I'd love to buy it a lower price].

Forbes.com