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19 March 2008

The stock markets seem to have more than got over the jitters that last summer's slump in residential construction provoked. Heavy equipment stocks have been back in favor, particularly in the second quarter of this year, and this has driven a surge in share prices.

In fact investors have been buying into the sector almost relentlessly over the three-month period, pushing ACT's Heavy Equipment Index (HEI) to a record high of 185.41 points in late June.

On a rolling 12 month basis, this helped the Index to a near 30% rise compared to mid-summer last year. On this timescale, it has once again overtaken the various mainstream stock market indicators, the best of which has been the Dow, with a rise of just under 25% over the same period.

The ACT HEI has been in this position before - in fact for most of its 2½ year history, during which time the heavy equipment sector has been on a remarkable roll. But a fact of life is that stock markets are volatile, cyclical stocks like heavy equipment especially so, and that sharp climbs inevitably lead to some sort of downward correction.

There have been two of these for the mainstream markets over the last five quarters - one in May last year, and one this February. There have been more in the equipment sector because Caterpillar's quarterly results and updated profits forecast tend to move the whole sector. The company is after all the largest construction equipment maker in the world, and is taken by investors as a Bellwether for the entire industry - even sectors like cranes, which clearly move on a different cycle to general construction machinery.

So, if there is going to be a downward correction for the ACT HEI, it will have come on July 20th, when Cat announces its second quarter results. The next red letter day will be October 19th and the company's Q3 numbers.

In my opinion, the ACT HEI will slump sharply on one of these two dates, probably the midsummer one. The Index has not rallied this sharply for this long before, and I find it inconceivable that this pace can be maintained for another month - let alone another four until the Q3 results announcement.

Having said that, a correction is not the end of the world, and does not necessarily signal recession. These moves are about investors taking their profits out of the stock markets, and allowing stocks to return to more realistic valuations, based on profit forecasts. The ACT HEI has recovered from such setbacks in the past, and if the economy stays strong it should do it again.

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