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Every day, I still look for the price of No. 1 heavy melt steel scrap.

-- Alan Greenspan, The American Iron and Steel Institute's annual meeting, 1997

Alan Greenspan was fond of tracking scrap prices and believed they were an important indicator of economic health, especially to anticipate a recovery or recession. I wanted to check in on this indicator to see what it is signaling about today's economic climate.

Scrap metal is unique amongst many indicators tracked by market professionals to gauge economic activity as it is free from any sort of speculation. Scrap metal typically comes from vehicles, buildings, and appliances. In the US, it is an export industry and serves as a critical source of raw material for the steel and aluminum industry such as United States Steel Corporation (NYSE:X) and Alcoa Inc. (NYSE:AA).

Further, it is a bottom up industry with individuals or small businesses, primarily, stripping metals and taking them to scrap dealers, where payment is given based on the market price. The scrap metal is then resold, melted down, and then bought by industrial companies.

Therefore, changes in scrap prices are a good measure of trends in industrial demand and production. For these reasons, Mr. Greenspan considered scrap to be an effective economic indicator as opposed to many economic figures whose efficacy is tainted due to its reflexivity with the markets.

The chart below shows scrap prices over the last 2 years:

(click to enlarge)

As the chart shows, scrap prices have significantly softened over the last 2 years. This does bring the validity of the economic indicator somewhat into question as the iShares Russell 2000 Index (NYSEARCA:IWM) and the SPDR S&P 500 ETF Trust (NYSEARCA:SPY) have remained quite robust during this period. Even most industrial stocks are not corresponding to scrap prices, however stocks in the scrap business such as Metalico, Sims Metal Management, Schnitzer Steel, and Industrial Services of America have correlated tightly with scrap prices.

The performance and trend of scrap prices is stunningly similar in trajectory as one key index, which like scrap prices have not participated in the strong performance of most assets since the March 2009 bottom.

(click to enlarge)

Above is a 2 year weekly chart of the Shanghai Stock Exchange. Clearly, this index is still suffering from the effects of excess optimism during the 2007 bubble in Chinese equities. In fact, it is hovering around its 2009 lows, in contrast the S&P500 is more than 100% above its 2009 lows. I think the woeful performance of scrap metal makes more sense in context with the anemic performance of the Chinese economy. The iShares FTSE/Xinhua China 25 Index (NYSEARCA:FXI) is a good proxy for the Chinese stock market.

China constitutes the world's largest source of demand for scrap and the primary source of growth in demand of scrap over the last few years. Therefore, in the near term I think scrap metal performance will continue to be tied to China. In this recovery cycle, scrap metal has been a poor indicator for the US economy but a very good indicator for the Chinese economy.

Conclusion

Scrap metal prices are not reflecting a strong economy, and in this cycle has not performed very effectively per Mr. Greenspan's expectations. Although, I think watching scrap prices remains a useful tool, it clearly is prone to failure, more so this cycle than prior ones. Anyone relying on scrap prices would have been bearish since early 2010, which obviously was an incorrect stance.

I will continue to monitor scrap prices as a pulse for the Chinese economy and the industrial sector, which has largely been a laggard since the March 2009 bottom. I do believe that this market rally looks somewhat tired and is in need of new leadership, if this bounce in scrap holds it could be a sign that industrial stocks are ready to move from laggard to leader.

Of course, there is an alternative interpretation that the weakness in scrap prices is a leading indicator that the US economy is tipping into recession. However, this conclusion is suspect because scrap prices have been trending down since 2010 and no recession has materialized, while stocks are threatening all time highs.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.