Investors woke up Friday to the news that Chinese Imports slumped 15.3% compared to January 2011; the worst reading since August 2009. Meanwhile, the nascent Greek austerity agreement announced yesterday is already unraveling as European officials demanded the measure gain approval in the Greek Parliament prior to any aid being released.
With the split between the improving U.S. economy and the weakness in the rest of the world getting ever wider, even as markets rally, it's more important than ever to position your portfolio in the right sectors. According to value investor Vitaliy Katsenelson, author of "The Little Book of Sideways Markets," the risk facing investors is falling into "value traps" in the form of the deep cyclicals.
Companies like Caterpillar (CAT), Joy Global (JOY), and Deere (DE) "look cheap on a P/E basis, many of them trading at 10 or 11 times earnings and if you look at the past they are growing 10 - 15% a year," says Katsenelson. As is always the case in markets, assuming the future will be an extension of the past can get you in a lot of trouble.
Global economies went from the bubble of the mid aughts straight to massive stimulus in the wake of the 2008 financial crisis. The result is the cyclicals never fully suffered through the meltdown as much as other groups as countries replaced private building demand with government works.
As austerity measures take hold in Europe and China seemingly slowing despite its best efforts the cyclicals are ripe for a contraction. The reason those low P/E multiples are a trap is, in Katsenelson's view, the earnings portion of the equation is going to shrink.
"Caterpillar margins today are about 8 - 9%, historically their margins are between 3 - 5%," he notes. With shrinking demand, either revenues or margins will be hit and that spells bad things for the stock.
Running back of the envelope numbers. If a company trading for $100 per share and a P/E of 10x sees margins decline from 10% to 5% the stock either suddenly looks expensive at a 20 P/E or drops to $50. Neither scenario is good for the stock in question.
Katsenelson isn't screaming "sell" and he's certainly not bullish. He's laying out the risk and pushing the idea that investors just walk away from the cyclical sector. In a bull vs. bear / buy or sell world the simple "AVOID" call is an underrated, critical part of the investment process.
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