Shanghai's New Surprise

Eight people in Shanghai have died this year after falling
into uncovered sewers, China’s Xinhua News Agency reports.
Meanwhile, the shares of U.S. Steel have also fallen into a
black hole…Maybe there’s a connection.

As Chinese steel production soars, so does demand for all
forms of iron – whether that form be "ore pellets" from
Brazil or manhole covers from Shanghai.

"Shanghai, home to Baoshan Iron & Steel Co., which supplies
half the steel used by China’s carmakers, loses so many
manhole covers that the local water bureau publishes a
daily tally on its Web site," Bloomberg News relates. "More
than 4,740 have been purloined since the beginning of last
year, including 99 this month.

"From London to Kolkata, India, scavengers are plundering
anything that contains iron," the New York mayor’s news
agency continues. "Prices in the $85 billion global scrap
market have tripled since 2003 as China has sucked in
recycled metal from around the world."

China’s booming steel industry is also inhaling vast
amounts of iron ore and coal – two key ingredients of
steel-production. China surpassed Japan to become the
world’s biggest iron-ore buyer in 2003. As the country
inhales growing quantities of iron ore, it exhales growing
quantities of finished steel. China lifted it steel
production by a stunning 38 percent in May, adding tonnage
equal to almost the supply of Germany, France, Spain and
the U.K. combined.

Not surprisingly, therefore, the prices of iron ore and
coal are both rising sharply, thereby driving up the cost
of steel production for every other steel mill in the
world, including those carrying the U.S. Steel logo. In
short, Shanghai’s stargazers are not the only casualties of
China’s booming steel industry; so are the steelmakers who
dare to compete against the Chinese

The sharply rising cost of steel production would not be
unbearable if steel prices were keeping pace, but they
aren’t. U.S. steel prices fell for the ninth straight month
in June – down a sharp 35% from a record $756 a ton in
September, according to Purchasing Magazine. The prices of
most other commodity steel products are also falling.

Unfortunately for U.S. Steel, therefore, input costs are
rising while revenues-per-unit received are falling. Blame
the Chinese. (Go ahead, everyone else does). The declining
share price of U.S. Steel since February amply reflects the
grim situation in which "Steel" now finds itself.
Curiously, however, the share prices of most major coal and
iron ore companies continue to float near all-time highs.
Something might be wrong with this picture. The selling of
steel stocks might be overdone, at least relative to other
steel-related issues like Peabody Coal and BHP.

If steel prices fail to recover, steel production will
drop. Already, several U.S. steel makers have trimmed their
production forecasts for the current quarter. At some
point, we would imagine, demand for coal and iron ore would
also decline. And if coal demand stalls a bit, we would
expect the stock prices of companies like Peabody Energy to
stall as well.

As the chart above illustrates, steel stocks and coal
stocks shared a magnetic attraction for one another…until
about three months ago. But in April, their polarities
suddenly reversed – steel stocks tumbled, while coal stocks
continued rising. To be sure, these two stocks rely upon
different underlying dynamics, but not as different as
their divergent price trends would suggest. The two share a
common root system – a root system nourished by global
economic growth. Therefore, coal stocks are not likely to
continue flourishing while steel stocks wither.

If the steel industry is indeed beginning an important
downturn, neither the coal or iron ore industries will
enjoy a lengthy immunity. "The balance of risks has moved
in favor of a small price reduction for iron ore and coking
coal," predicts Goldman Sachs analyst Malcolm Southwood.
BHP Billiton, Rio Tinto Group and other miners will
struggle to hold on to record prices for raw materials as
steelmakers are faced with declining profit margins, the
analyst warned as he cut his 2006 and 2007 earnings
estimates for BHP Billiton and Rio Tinto, the world’s No. 1
and No. 3 iron ore miners respectively.

Net-net, we’d be a buyer of steel stocks relative to coal
stocks, or relative to iron ore stocks – "relative" being
the operative word. A buyer of steel stocks would also
enjoy the psychic support of relatively (there’s that word
again) low valuations. Most steel stocks sell for a paltry
4 times estimated earnings, compared to 20 times for
Peabody Coal.

"U.S. Steel has shown almost no net progress in the stock
market in the last 12 1/2 years," John Dorfman relates in a
recent column for Bloomberg News. "Saddled with expensive
pension and health-care benefits to retirees, and burdened
by international competition, the Pittsburgh company has
frequently disappointed investors. The stock sold for
$34.80 a share on July 1, barely above its price of $34 at
the end of 1992. It was down 32 percent last quarter as
steel prices declined and China seemed to be moving toward
self-sufficiency in steel faster than anticipated.

"So disillusioned are investors," Dorfman continues, "that
U.S. Steel shares sold for 3.37 times earnings, 0.98 times
book value (corporate net worth) and 0.28 times revenue on
July 1. Those are ratios I find appealing…

"I [also like] Commercial Metals (NYSE: CMC), which was
down more than 29 percent last quarter…This Irving,
Texas, company manufactures, recycles and sells steel and
other metals. Although Commercial Metals stock bounces
around, the company has been consistently profitable, with
at least 18 years of consecutive positive earnings. At six
times earnings, 1.7 times book value and 0.23 times sales,
I consider Commercial Metals a bargain."

To be very clear, you editor is not recommending a purchase
of U.S. Steel or a sale of Peabody Coal or BHP. He is
merely highlighting the fact that these three securities
are unlikely to diverge from one another for much longer.
One way or another, Steel stocks, coal stocks and iron ore
stocks are likely to regain their magnetic attraction to
one another.

Long term, we expect all three sectors to flourish. So
don’t forget to keep your eyes on the ground when walking
in Shanghai.

Did You Notice…?
By Carl Swenlin

In the last 50 years there have been only two major trends
in the long bond yield — rising to a top in 1981, and
falling since then. The chart presents a nearly perfect
example of parabolic rise, followed by the inevitable
collapse of the parabolic, and finally, the steady decline
back toward the original base.

In a very long-term view the ultimate base is at about
2.5%, but I chose to feature this chart because there is
some evidence that the long decline may be over. The
evidence isn’t incredibly strong, and the trend is still
down; nevertheless, early signs of a possible bottom have

First, there is modest long-term support around 4% provided
by the consolidation between 1959 and 1966, and the price
index has a potential double bottom setup just above that
support. Second, the weekly PMO (Price Momentum Oscillator)
is oversold enough to support a rally.

To clarify, we cannot say that a bottom has formed until
there is a rally that exceeds the 2004 top, but the seeds
of that rally have been sown.

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