Nothing beats a Deere…Except maybe a Caterpillar

• Posted by Greg Harmon
• on January 14th, 2011

I have been on the record as liking both of these stocks.  Until yesterday I was long Deere (Ticker:DE), and Caterpillar (ticker:CAT) was a top trade pick from Sunday.  Performance of both stocks has been very strong recently.  Below is the relative performance chart of the two over the last 12 months.

Their performance had been highly correlated until late November when CAT leaped ahead of DE. But recently DE outperformed and closed the performance gap. Parity again.  Riding DE for that gap close was a good trade but what about the future?  Lets look at the pieces.  Below is the chart for DE.

Deere has had a strong move up since August. Recently it has received many analyst upgrades. But technically it is getting extended. Yesterday’s close exceeded the top of the Bollinger bands and its Relative Strength Index (RSI) at 81.78 is giving an overbought signal. It may be ready for a short term pullback or sideways consolidation phase. Now look at the chart of CAT below.

This stock has been consolidating for nearly a month.  The Bollinger bands are getting extremely tight.  RSI has fallen to a lower level and the Moving Average Convergence Divergence (MACD) indicator is starting to turn up.  This is ripe for a break out. The previous price history on the chart suggests that there is potential for a move up to 110.

You could just buy CAT for this move. But how can you maximize this relationship? If you believe that DE is about to pullback and CAT about to rise, profiting from this relationship can be be maximized using a pairs trade.  Below is a ratio chart of the two stocks.

Notice that the ratio has been in a symmetrical triangle pattern for about a year.  The RSI of the pair is getting to oversold with the ratio is heading lower toward support at the bottom of the formation.  Also note that every time the RSI has hit this low level it has bounced and the ratio moved higher by more than 10%. If you are not convinced that CAT is ready to run enough to buy it out right, look for the reversal in this ratio and enter the pairs trade of long CAT and short DE. the objective would be at least to move to the top of the triangle at 1.15.  As a reference that would be equivalent to CAT moving to 110 and DE staying at 95.

Two ideas for today. Alone or in pairs. Trade’m well!

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