Know When To Hold em' Know When to Fold em'

A reader says/asks "Steel stocks look awfully cheap and commodities are running higher again, what do you think about getting long some steel here?" Thanks for the layup comment/question; here's the long and short of what I think.

My short answer is: in my opinion, if you are talking about a short term trade, you may be right to want to be long and steel take one more run higher before a substantial decline; however, if you're talking about a longer run commitment on the long side for an extended bull run then I'd have to disagree. Why? Simply because we are of the opinion that we are more likely than not in the late innings of the bull market in steel. We also think the industry's cyclicality is being underrated. Its quite possible that peak earnings are in the books and few want to admit that.

Now for the long answer:

The longer term technical trends are still favorable. Valuation (on Earnings, Cash Flow and Free Cash Flow) is still on the cheap side when you consider either trailing, current or forward earnings. The group and most of its members are still performing well on a relative basis. Most of the major steel companies have posted disappointing earnings for 2-3 quarters now. However, disappointing results were not very surprising and bottom lines have held up much better than bears would have guessed.

Expectations have been guided conservatively so bullish sentiment appears to be moderating. Nevertheless, I sense that sentiment is still tilted toward the bullish camp as most commodity prognosticators and market pundits seem to be either raging bulls or cautiously optimistic. So with technicals and fundamentals more supportive of the bull case, we think it makes most sense to either be on board the prevailing trend if you are a trader or stay long if you are an underweighted investor. If you are overweight metals and commodities as a longer term investor at this point, then I'd consider starting to scale out of some of that exposure; especially in steel.

Why be negative in the intermediate or longer term? Because we doubt that the next big move is up. Why? Because fundmentals have clearly deteriorated and may very well get worse sooner than most think. And because the sheer cyclicality of the steel industry seems to be underappreciated. Most seem to believe that steel companies are immune to the recent changes in U.S. and global macroeconomic conditions. We beg to differ.

Some of that has to do with demand being more resilient than expected, some of that has to do with the weak dollar, and some may have to do with the successful global capacity consolidation we've seen at the hands of the Mittals of the world. Some may have to do with cost inflation and higher shipping costs keeping prices more elevate than would otherwise be the case. All of which is understandable. Nevertheless, we still think the cyclical influences will have their say - it's just a matter of time.

If growth slows globally (as I expect), then it's only a matter of time until demand softens, inventories build, and shipments slow. Meanwhile, the cost side of the equation would likely lag on the downside. Since this is happening slowly, I would think that capacity and overproduction would also become an issue. If/when revenues slowed and costs could not be cut fast enough negative operating leverage would become an even bigger issue and profits would be under serious pressure. When estimates are reduced further, shares wouldnt look so cheap. Steel stocks would sell off and the trend and momentum would go the other way; and so would a trader's reasons to be getting long.

Good Night and Good Luck.