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Stocks in this article: CAT

Given that stocks should forecast earnings, how did CAT do during that period? How about a decline to $22 from $84, about a 75% retracement.

So, if you believe that a collapse in Europe, which seems more imminent by the day, will crush credit and kill many big construction projects that need Caterpillar tractors and engines, you ain't seen nothing yet. Caterpillar's headed to $29 from its high of $116.

At that price you would have a 6% yielder, certainly accidentally high, but CAT has boosted its dividend. But wait a second. If CAT's doing that badly, the dividend will be sliced and sliced big.

So, now let's think about the owner of CAT shares. It is reasonable to presume that the owner might be fearing exactly what happened in 2008-2009.

Now, let's look at it another way. Rather than calculate the loss in stock price relative to 2008-2009, let's look at the earnings decline analogue. Right now analysts estimate that CAT is going to earn $9.74 a share. You give CAT the same earnings per share crushing you got in 2008-2009 and you have earnings bottoming at $4. What's the appropriate multiple for a company that could earn $4? Right now it's about 9x future estimates. That puts the stock at $36.

Still nothing to write home about.

So, you can see how these sellers might think they are getting ahead of a gigantic decline.

Here's the issue, though. The price-to-earnings ratio would not contract like that, it would most likely expand as people recognize that CAT could be in a trough earnings phase. In those cases, P/Es go up, not down. You could see an expansion say, to roughly 16x to 17x earnings, as I have seen P/Es almost double in these situations. That puts the stock at roughly, say, $70 in earnings based on the $4 figure.

Not coincidentally, that's exactly where it traded to in the bottom of 2011, as stock traders figured on exactly that kind of earnings decline. At that price it does yield 4%, where other industrials have held.

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