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Market Cycles and Investor Blindness

This week’s Blue Harbinger Weekly focuses on broad market cycles, and how quickly investors forget about them and become blind to their dangers and opportunities.  We consider the staggered market cycles of the US versus international economies, and the impacts on specific industries such as railroad companies and heavy machinery manufacturers.

For starters, the US has always been ahead of the European economy in dealing with the financial crisis, but considering the interconnectedness of global markets, the two cannot diverge too much.  For example, the US Fed is set to raise rates later this month while the European Central Bank continues to be dovish.  Unfortunately for US companies with international operations, they cannot pull ahead even though the US economy is stronger because the very strong US dollar makes their exports more expensive and less competitive.

For example, this week’s Stock of the Week, Caterpillar (CAT), is getting destroyed by the strong US dollar and lagging international market growth.  Specifically, international sales have fallen off a cliff because those economies are not recovering as quickly as the US, plus the strong US dollar makes CAT’s exports more expensive.  However, with many investors ready to throw in the towel on CAT, it’s actually a great buying opportunity as the market cycle will eventually turn and Caterpillar will rebound with a vengeance.  In fact, historically, when CAT has rebounded it rebounds big and fast.  We can’t predict the exact timing of the rebound, but when it happens the company’s stock price will rebound dramatically and quickly.

We don’t own Caterpillar stock, but we like it.  And if CAT stock falls much further in the next few months then we will give serious consideration to selling something in the Blue Harbinger 15 and replacing it with CAT.  However, CAT is an industrial stock facing many of the exact same headwinds as our existing BH 15 Industrial stock, Union Pacific Railroad (UNP).  UNP has also fallen significantly this year, and it will also rebound big and fast when the market does turn.

Continuing with the railroad theme, news of Canadian Pacific Railroad’s (CP) proposed merger with Norfolk Southern (NSC) was met with hostility by Norfolk Southern.  (We recently wrote about Canadian Pacific, and you can read our views here).  Across the railroad industry, stocks are suffering (from a depression in the market cycle) and they’re doing just about everything they can to prudently improve efficiency ratios.  However, Norfolk Southern believes Canadian Pacific’s proposed merger is too short-sighted and would ultimately destroy long-term value.  Canadian Pacific is heavily influenced by hedge fund investors notorious for being too short-sighted.  The proposal is just a sign of how far the industry has fallen in the market cycle, and it will be interesting to see how it plays out.  However, it will be more interesting when the industry eventually rebounds with a vengeance and our Union Pacific stock come screaming back with enormous gains.  No one can predict exactly when, but it will happen.

On a separate note, we continue to follow burrito maker, Chipotle Mexican Grill (CMG).  After suffering a recent E. Coli outbreak that impacted nine states and sickened 52 customers, management provided updated earnings guidance, and it is ugly!  They lowered fourth quarter earnings estimates to $2.45 - $2.85 per share, down from 4.06 per share before the E. coli outbreak.  We continue to watch this story closely because we believe Chipotle will eventually recover from this episode.  Specifically, once we have more confidence that the outbreak is behind us we may look to purchase shares if the price is still low.  Chipotle was a recent Stock of the Week (read more here), and we may eventually replace McDonald’s (a Blue Harbinger 15 stock) with Chipotle (again, depending on the business outlook and stock prices).

The bottom line in this week’s Weekly is don’t run from the lower end of the market cycle, because that is usually the exact wrong thing to do.  And never get overconfident that you can predict the exact timing of when the cycle will turn because the market will humble you.  Be smart.  Invest in a diversified portfolio of quality companies for the long-term.


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