In the world of cyclical stocks certain correlations commonly exist. For instance, in the semiconductor and semiconductor equipment sectors book to bill ratios are important in predicting increasing or decreasing demand for the companies’ products. As booking ratios increase, the stocks generally increase in the near to intermediate term; exactly the opposite is true if the ratio contracts.
For farm equipment stocks, the price of corn is frequently correlated with the performance of the sector. The relationship is logical since farmers tend to purchase considerably more equipment when they are generating a larger than normal amount of cash. Note the relationship between the price of corn and the stock prices for Deere (NYSE:DE), Lindsey (NYSE:LNN), and Agco (NYSE:AGCO):
Government stimulus programs such as accelerated depreciation tend to add additional fuel to an already hot fire. Accelerated depreciation allows farmers to write off up to 100% of the cost of their equipment purchases in the same year in which they made the transaction. The ability to defer or reduce taxes in the current tax period provides a huge motivation to purchase additional equipment, particularly if the price of corn is high and the farmer is sitting on a bumper crop.
The effectiveness of stimulus programs in "pushing up" the timing of purchases is evident in viewing the demand which was created in the "Cash for Clunkers" program, tax rebates of up to $1500 on energy efficient home improvements, and first-time homeowner tax credits. Unfortunately in each case after the stimulus was withdrawn, the demand for these products quickly subsided. Not only did the demand subside, in most cases the demand was reduced well below its pre-stimulus level.
In all the cases described above, the latent demand for the "discounted" products was quickly filled; in effect, the government stimulus had further altered the natural depreciation or replacement cycle for the industry which was already super-charged by two periods of extremely high corn prices. Pushing up the replacement cycle will likely result in at least an intermediate term delay before the normal replacement cycle in the farm equipment sector returns. Simply stated, farmers can only buy so much equipment in a limited period of time. After that point sales lag until a new replacement cycle ensues.
In the case of corn prices another artificial demand stimulus has the potential to soon be withdrawn. In June, the senate overwhelmingly voted to end the ethanol subsidy for refiners and eliminate the corn ethanol tariff, although the president threatened to veto the cut to the corn subsidy if legislation moved through the house. However, in light of the current fiscal debate, subsidies which are unilaterally unpopular are likely to be among the bargaining chips which the White House would concede.
Withdrawal of corn ethanol protectionism would almost certainly result in a quick and dramatic drop in corn futures. A drop in corn prices coupled with the lack of intermediate latent demand created by tax incentives and stimulus programs is likely to push the replacement cycle for farm equipment well out into the future. When demand quickly subsides in cyclical businesses, stock prices tend to correct abruptly. That statement can be confirmed by merely glancing at the charts provided earlier in the article.
Farm equipment stocks have become extremely risky propositions as the price per share of these companies generally correlates with the fluctuations of corn prices. If the US government repeals corn ethanol tariffs and abolishes corn ethanol subsidies, the price of corn would almost certainly experience a material drop in price and demand. Additionally, the depreciation cycle of US farm equipment has been materially altered by a second round of high corn prices and government stimulation in the form of accelerated depreciation.
Investors need to constantly monitor business cycles when they invest in highly cyclical companies. Not only do they need to pay attention to information which correlates with rising or declining demand in their sector, they also need to anticipate developments which might quickly crash their sector.
Nothing is more ephemeral than the forward earnings of any company; that statement applies in spades for cyclical companies. Successful investors and traders understand that fact and spend a good deal of their time analyzing potential pitfalls which could affect future earnings.
No position in any of the equities mentioned