Steel Stocks: Head Fake Or Legitimate Breakout?

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Includes: AKS, MT, NUE, STLD, X
by: Lou Basenese

The world's newest Nobel Prize-winning economist, Robert Shiller, didn't mince words this weekend. He told Germany's Der Spiegel magazine, "I am most worried about the boom in the U.S. stock market." Why? "Because our economy is still weak and vulnerable," says Shiller.

While I don't share his concerns about U.S. stocks (yet), I'll concede that the economic recovery has been less than robust. Nowhere has this been more evident than in the steel industry.

Titans in the sector, like Nucor (NYSE:NUE), are still struggling to recover. In the first nine months of 2013, sales and net income both decreased by roughly 14%. Compared to peak activity in 2008, Nucor's sales and net income over the last 12 months remain 21% and 75% below their annual highs, respectively.

And yet share prices for Nucor and its peers - like U.S. Steel (NYSE:X), AK Steel (NYSE:AKS) and Steel Dynamics (NASDAQ:STLD) - have been perking up lately. Take a look:

Click to enlarge

Over the last three months, they're all up by double-digit levels. Heck, the recent rallies by U.S. Steel and AK Steel make the S&P 500 Index's gains for the entire year seem miniscule.

Is this the beginning of a legitimate recovery, or merely a head fake that should be ignored? It's time to find out and invest accordingly…

High Risk, High Reward?

Steel producers play a crucial role in the global economy, since the metal is used in everything from automobiles to bridge building. As such, steel companies can serve as an excellent harbinger of better economic times ahead, which brings us back to Shiller's observation.

Even as the global economic recovery extends into its fifth year, steel demand remains lackluster at best. Case in point: ArcelorMittal (NYSE:MT), the world's largest steel producer, recently reported a narrower loss for the third quarter. But the company said it was only "cautiously optimistic" about prospects for 2014. Now, it's hard to put much stock in that assessment. Earlier this year, the company assured investors that demand would be strong in 2013, and that has hardly come to fruition.

At the same time, the World Steel Association is only forecasting a modest 3.3% uptick in steel demand for 2014, compared to a 3.1% increase for this year. Nevertheless, the analysts over at Goldman Sachs recently upgraded a trio of steel stocks from "Sell" to "Buy," based on the outlook for stronger domestic demand. I wouldn't follow their lead, though.

We're heading into the traditionally weakest quarter for steel companies. Not to mention, the industry is still suffering from overcapacity. What's more, cheap foreign steel promises to keep a lid on any meaningful price increases - which, in turn, will dampen profitability. Or as the analysts at Wells Fargo put it, "We expect pricing to weaken meaningfully in H1 2014 due to increasing levels of import competition… [And we] believe there is now greater risk to 2014 estimates."

Greater risk? That doesn't sound like the makings of a legitimate recovery to me. And these aren't the conditions necessary to support a prolonged rally in share prices.

Bottom line: I'm convinced that the latest price swings for steel stocks are merely a head fake. So a short-term correction promises to be close at hand. If I'm wrong, so be it. Steel stocks have a long way to run before they get back to their 2008 peaks.

Unlike the S&P 500 that recouped all its losses and keeps hitting new all-time highs, the average steel stock is still off about 60% from its peak. So there will be plenty of time to "go long" steel stocks and still profit handsomely. For now, let's keep a close watch on the trend.

Disclosure: None.