Steel ETF Stocks May Be Overvalued

The sector has enjoyed a strong run, but with supply tight, there may still be room on the upside.
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While the broader markets have been struggling to find their way in the first few months of the year, the steel sector has been able to find direction.

The Dow Jones U.S. Steel Index is up 18.9% year to date vs. a 6.4% decline in the

S&P 500

. One way for investors to play the steel trade is the

Market Vectors Steel ETF

(SLX) - Get Report

, which is up 11.0% this year and 61.4% over the past 52 weeks.

Rio Tinto

(RTP) - Get Report

,

Companhia Vale Do Rio Doce

(RIO) - Get Report

and

ArcelorMittal

(MT) - Get Report

are the fund's top three holdings and account for more than 40% of the fund's net assets. Each of these stocks presently trades near its 52-week high.

Other strong performers for the fund include

U.S. Steel

(X) - Get Report

and

Mechel

(MTL) - Get Report

. Mechel moved nearly 10% higher on Wednesday and is up more than 300% in just the past three years.

These runups raise the questions of whether the steel industry can maintain its momentum and whether SLX is a sound play for investors.

With U.S. steel demand approximately 30% ahead of its supply and the dollar weakening, the conditions have been ideal for many of these steel names.

"With imports down and distributors having cut inventories last year, supply is relatively tight right now," says Leo Larkin, an equity analyst at Standard & Poor's.

Sam Halpert, a senior analyst at Van Eck Global and co-manager of the

Van Eck Global Hard Assets Fund

(GHAAX) - Get Report

, sees this lack of supply as being especially favorable to steel investors.

"Steel prices have gone up dramatically in the last three months in the face of poor demand," he says. "This trend is atypical, and if we were to see decent demand at some point in the second-half of 2008, prices could really move."

In 2004, steel prices also rose sharply and the Dow Jones U.S. Steel Index increased 66.2% over the course of the year.

Bob Richard, a senior research analyst for Longbow Research, believes there is strong support for current steel prices. "They are sustainable -- more sustainable than they were in 2004," he says. "We could see even sharper price increases this summer than we did in '04."

As for SLX itself, Harvey Hirsch, a senior vice president at Van Eck Global, sees the Market Vectors ETF as being suitable for everyday investors looking to gain access to the steel market.

"It reduces your risk by giving you instant diversification across the sector," he says.

Halpert agrees and adds, "You can benefit from steel demand in areas such as the Middle East, which might be hard to pinpoint."

Richard is generally bullish on the sector, but favors an approach of going with individual companies.

"Steel stocks tend to trade in the same direction, but there is enough differentiation between the names to make it worthwhile to pick individual stocks for those willing to do their homework."

As far as individual names go,

Nucor

(NUE) - Get Report

and U.S. Steel are among the more attractive names that Halpert sees.

"Nucor has a good valuation, a good management team, is integrating on the scrap side and is buying back shares," he says. "U.S. Steel is well-positioned from a long-term perspective given the demand for their tubular products, which are used in the oil and gas industry."

One other name that Halpert likes is

Commercial Metals Company

(CMC) - Get Report

. The Irving, Texas-based company has benefited from record scrap sale prices and recently reported a 21.1% increase in its second-quarter net sales on a year-over-year basis. Commercial Metals also repurchased 3.1% of its outstanding common shares for its quarter ended Feb. 29.

"They are integrated on the scrap side and are well-positioned in Europe," Halpert says.

Regardless of whether new investors to steel decide to go with the ETF or individual stocks, steel can be a high-risk, volatile investment.

"So far steel companies have been able to pass on cost inflation, but the question is, will they be able to if demand continues to remain weak," Halpert says. "There have been sharp periods of correction over the past four years. It wouldn't be uncommon for a steel stock to drop 30% over a short period of time."

Billy Fisher owns shares of Companhia Vale do Rio Doce.