After the meltdown

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Steel Stocks Crushed — Can They Bounce Back?

Despite a rather bullish year for the broader market, materials stocks in general have had a rough go of things in 2012 as the global economy has seen manufacturing troubles. The steel sector in particular has been a painful area for many investors.

And sadly, after a disappointing start to the year the losses have mounted in earnest in the past month or so.

Check out these returns:

  • ArcelorMittal (NYSE:MT), -16% year-to-date vs. 12% for the S&P 500, and -2% since Oct. 31 vs. a flat S&P 500.
  • U.S. Steel (NYSE:X), -17% YTD and +3% since Oct. 31
  • Vale (NYSE:VALE), -18% YTD and -4% since Oct. 31
  • AK Steel (NYSE:AKS), -50% YTD and -21% since Oct. 31
  • Cliffs Natural Resources (NYSE:CLF), -53% YTD and -20% since Oct. 31

So are steel stocks a bargain now that the negativity has been priced in, or will the meltdown continue?

The Bullish Case for Steel Stocks

Sentiment-driven rotation: For starters, let’s admit steel is one of the most obvious cyclical plays out there. A stronger global economy equals stronger steel demand for manufacturing and construction — it’s as simple as that. So it’s no surprise that sentiment and optimism can lift these stocks even when a rally seems at odds with the headlines. As we saw in August, baffling rotations into steel can occur without any “proof” behind them — just hopes of a recovery and improvement in sentiment. Any favorable news from the eurozone or Congress could have a favorable impact on cyclicals.

Seasonality: Furthermore, according to a Credit Suisse report in Barron’s, steel stocks have added an average of 26% annually from November to April over the last decade (barring 2002 and 2008 recessions). Not a bad track record.

Inventories low, relatively speaking: China inventories are at their lowest levels since 2009 despite continued general problems of oversupply.

China shows signs of life: Recently, the HSBC Flash PMI report for China just hit a 13-month high. And more important, the reading of 50.4 is the first positive reading in more than a year. (For the PMI index, anything above 50 is growth, while below 50 is contraction.) China remains the biggest engine of global manufacturing and the largest steel producer in the world, so this is bullish for steel stocks.

Improving analyst outlooks: Since Sept. 1, U.S. Steel has seen “buy” ratings from Argus and Standpoint, with targets of $31 and $34, respectively. That’s a minimum 40% upside. And since Nov. 1, smaller producer AK Steel has improved to “hold” at Dahlman Rose and “overweight” at Barclays — Barclays has a $5 target, roughly 25% upside from current valuations.

Inflation: By Ben Bernanke’s own admission, central bank policies right now are designed to focus on maximum employment and support asset values … with inflation an afterthought. That means a modest rate of inflation is all but assured, and that will ultimately drive up steel pricing as it does for other commodities from corn to gold to crude oil.

The Bearish Case for Steel Stocks

Oversupply: The world has excess amounts of steel, especially in the U.S., and that is preventing steel prices from ever moving significantly higher. And based on a recent Wall Street Journal report, the “capacity glut” will not be changing anytime soon — production hovers around 1.8 billion tons and demand remains just 1.5 billion on the order side. Not good math for steel stocks, to be sure. Making matters worse is the kerfuffle in France as the president is threatening to nationalize an ArcelorMittal plant to preserve the jobs — which would also preserve this capacity, contributing to a global oversupply.

Manufacturing still soft: According to the JPM Global PMI report from the Institute for Supply Management, global manufacturing contracted for the fifth straight month in November. So while China is showing signs of improvement, the worldwide momentum is to the downside, at least in the short term.

Correlation to Treasuries: A few weeks ago, Daniel Putnam shared this fascinating chart that shows how tightly correlated materials stocks are — particularly coal, steel and aluminum — to Treasury yields. You can read his full take here, but the gist is that the strength of U.S. debt compared with alternatives in the eurozone, coupled with ZIRP in 2013 (and beyond), will continue to depress yields next year, too. If this correlation stands, expect materials stocks from aluminum giant Alcoa (NYSE:AA) to U.S. Steel to be held back.

The Verdict: Tread Lightly

The data are conflicting, obviously, but I am of the mind that a cyclical recovery is in the cards for late 2013 or early 2014. That means investors should consider dabbling in materials stocks on a pullback — like the recent drawdown in steel stocks — in the hopes of entering at a good price before a widespread recovery boosts the sector.

Look, steel is ubiquitous. It’s used in skyscrapers, cars, dishwashers and everything in between. Roughly 95% of worldwide metal production focuses on steel and iron. If there is a significant increase in global economic output, it is a no-brainer that steel stocks are going to soar.

The problem is timing that recovery. The timing may not be perfect right now, but it’s better to be in nine months too early than nine months too late.

Consider that some investors mocked those nibbling at homebuilders Toll Brothers (NYSE:TOL) or Pulte (NYSE:PHM) in 2011. Well, who’s laughing now? TOL is up almost 80% in two years and PHM is up about 170%.

If you have the patience to sit on these stocks for two or three years, there’s a pretty good likelihood you’ll see the returns take shape.

If you have better things to do than park your cash in materials stocks and suffer as much as three years of volatility … well, look elsewhere.

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Jeff Reeves is the editor of InvestorPlace.com and the author of “The Frugal Investor’s Guide to Finding Great Stocks.” Write him at editor@investorplace.com or follow him on Twitter via @JeffReevesIP. As of this writing, he did not own a position in any of the stocks named here.

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