Which Story Line Will Steel Stocks Follow?

by Daniel Putnam | August 13, 2012 9:00 am

Which Story Line Will Steel Stocks Follow?

Steel stocks are attracting a great deal of investor attention these days: They’re cheap, the dividends are generally attractive and once they get moving, look out. So far, the summer has brought the latest revival in the steel names on hopes of central bank stimulus and economic news that has been somewhat better than expected. The results since the beginning of June have been very strong on balance:

Stock 5/31-8/9
US Steel 15.6%
Arcelor Mittal 14.9%
Nucor 14.9%
Posco 11.3%
AK Steel -2.2%
Cliffs Natural Resources -5.9%
Steel Dynamics 27.9%
Vale 3.4%

This isn’t the first time steel stocks have registered big gains behind a general improvement in investor optimism. The recent moves, while large, pale in comparison to those rung up by these same companies in October 2011 and January 2012. In both of these rallies, however, the moves in the stocks weren’t accompanied by a similar improvement in underlying industry fundamentals[1]. And in both cases, the shares eventually gave up their gains within a few months.

The situation right now is similar: While the stocks have been performing exceptionally well, there has been no change in the backdrop of slow economic growth and poor industry pricing[2]. In addition, China is maintaining elevated production levels at a time of declining demand, leading the country to rid itself of excess steel by dumping it into the export markets.

None of these factors bode well for industry profitability, even as comps grow increasingly favorable.

42754917 Which Story Line Will Steel Stocks Follow?[3]

Source:nerdsofsteel.com

This is reflected in the fact that earnings estimates[4] have fallen for all periods — this quarter, next quarter, 2012 and 2013 — for U.S Steel (NYSE:X[5]), Arcelor Mittal (NYSE:MT[6]), Nucor (NYSE:NUE[7]), Posco (NYSE:PKX[8]), AK Steel (NYSE:AKS[9]), Cliffs Natural Resources (NYSE:CLF[10]) and Steel Dynamics (NASDAQ:STLD[11]). The only difference among the various companies is the rate of decline. Until this trend is arrested, any rally in these stocks is suspect.

What Are the Charts Saying?

One of the most interesting aspects of the steel trade lies in the charts. Using the Market Vectors Steel Index Fund (NYSEARCA:SLX[12]) to aggregate the performance of the U.S. steel industry, we can see two defined reference points  — the upper trendline at $48.15 and the lower support at $40. A move above this upper trendline, which may be accompanied by a similar rise about the 200-day moving average, could well signal that an improvement in industry fundamentals may finally be on the way late this year or early next.

A break below $40, of course, would signal that the negative environment for steel is unlikely to improve anytime soon. For anybody who has skin in the game with a steel trade right now, these are the key chart points you need to monitor.

slx 1024x443 Which Story Line Will Steel Stocks Follow?[13]

Is Steel a Buy Here? It Depends

Ultimately, the way to approach steel right now depends on your time frame. For short-term traders, the sector still contains a great deal of danger since the disconnect between price action and business fundamentals that we saw in the October and January rallies is occurring once again. Playing chase during upturns in the steel sector has proven to be a dangerous game in the past year, and it will remain so until there is a technical breakout or an improvement in fundamentals.

On the other hand, investors who can withstand the risk and have the ability to hold on for a multiyear period can take advantage of the outstanding valuations in industry players that are likely to emerge from this downturn intact:

Stock Forward P/E Est 12-mo Yield
US Steel 6.2 0.9%
Arcelor Mittal 7.3 4.1%
Nucor 12.3 3.6%
Posco 9.8 3.2%
AK Steel 9.3 Unknown, likely cut
Cliffs Natural Resources 5.6 5.8%
Steel Dynamics 9.1 3.1%
Vale 5.9 6.2%

Buying stocks at this sort of valuation starting point has been a ticket to investment success over time, so the opportunity here is compelling — especially if China’s economy surprises to the upside. Also, the weakness in industry conditions is likely to result in capacity reductions, and a concurrent increase in profit margins, in the years ahead.

This long-term story — and not a desire to chase the recent rally — is the only reason to own steel stocks right now.

Endnotes:
  1. industry fundamentals: http://www.scrapmonster.com/news/steel-market-fundamentals-may-remain-depressed-longer-than-expected-in-q3-eurofer/1/6242
  2. poor industry pricing: http://blogs.barrons.com/stockstowatchtoday/2012/08/07/analysts-puzzled-by-steel-price-hike-stocks-keep-rising/?mod=yahoobarrons
  3. [Image]: http://investorplace.com/wp-content/uploads/2012/08/42754917.png
  4. earnings estimates: http://finance.yahoo.com/q/ae?s=X+Analyst+Estimates
  5. X: http://studio-5.financialcontent.com/investplace/quote?Symbol=X
  6. MT: http://studio-5.financialcontent.com/investplace/quote?Symbol=MT
  7. NUE: http://studio-5.financialcontent.com/investplace/quote?Symbol=NUE
  8. PKX: http://studio-5.financialcontent.com/investplace/quote?Symbol=PKX
  9. AKS: http://studio-5.financialcontent.com/investplace/quote?Symbol=AKS
  10. CLF: http://studio-5.financialcontent.com/investplace/quote?Symbol=CLF
  11. STLD: http://studio-5.financialcontent.com/investplace/quote?Symbol=STLD
  12. SLX: http://studio-5.financialcontent.com/investplace/quote?Symbol=SLX
  13. [Image]: http://investorplace.com/wp-content/uploads/2012/08/slx.jpg

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