Occam’s Razor is the principle that, when you’re making a decision, the simplest solution is the best one.
It applies to what we do here: Sometimes, the best way to pick stocks is the most obvious way.
Don’t overthink it.
Investors are doing that now: avoiding stocks of companies with bad balance sheets.
And they’re piling money into stocks of companies with good balance sheets.
If the economy is facing headwinds — say, a global pandemic or a trade war — you want stocks that will weather the storm best.
High debt on the balance sheet is a burden for companies and shareholders. This is Investing 101 in good times or bad.
Breaking down stocks by sector is another simple way to select or avoid stocks during tough economic times.
On June 19, I told you to avoid the industrial sector — specifically the construction equipment company Caterpillar Inc. (NYSE: CAT).
Today, I want to stick with that theme.
Steel companies are part of the materials sector.
They’ve bounced after hitting multiyear lows. Some investors think this makes them a buy.
But be careful. My analysis and Chart of the Week show us that we should be selling steel stocks — not buying them.
Don’t Buy the Bounce Too Early
We can use the VanEck Vectors Steel Fund (NYSE: SLX), which holds a basket of steel companies, to measure the sector’s performance.
The fund’s value dropped 52% with the broad market in the first quarter of 2020.
Then it rallied as much as 70% after its bottom in March.
That’s due to the market rally and the rising price of iron ore. Iron ore is the main ingredient used to make steel.
As you can see in the Chart of the Week, iron ore prices are up 28% since April and 36% in the last eight months:
But we need to be careful not to jump into steel stocks too soon.
The iron ore price has rallied because supply and demand fundamentals have improved.
Economists and investors expect it to continue.
These expectations, however, rely much on the outlook for the Chinese economy.
The COVID-19 pandemic hit China’s economy first.
And so, it emerged from lockdown first.
The rebound in China’s economic sentiment boosted iron ore prices.
Here’s why: China takes in 69% of global iron ore imports. It also accounts for 46% of global steel demand.
Chinese policymakers provided $198 billion of economic stimulus in the first quarter to ease the pain of COVID-19 shutdowns. Much of it is aimed at new infrastructure projects that would use steel along with other materials.
That supports economic and market sentiment in the same way stimulus has in the U.S.
But here’s the thing: The iron ore price looks like it’s overshot reasonable expectations for economic recovery. It will stall out or even decline in the months ahead.
And that’s what prices do. They overshoot to the upside and undershoot to the downside as investors buy and sell to fit their perceptions.
Rethink Iron Ore and Steel
The economic recovery this year has been uneven.
Yes, the COVID-19 pandemic shut down the global economy.
It did so quickly. And its fallout hurt some parts of the economy more than others.
But recovery is uneven no matter the kind of recession the economy faces.
Historically, industrial production is the area of an economy that takes the longest to recover from a recession.
Where U.S. gross domestic product took 20 months to recover from the Great Recession in 2008, U.S. industrial production took nearly 40 months.
That means lower demand for steel used in automaking, construction and other industrial applications — for a longer time.
Top holdings in the VanEck Vectors Steel ETF, an exchange-traded fund (ETF), include Brazilian iron ore producer Vale S.A. (NYSE: VALE) as well as steel producers Nucor Corp. (NYSE: NUE) and Steel Dynamics Inc. (Nasdaq: STLD).
Avoid those stocks for now.
Or, if you’re an active trader, consider them short-selling opportunities.
Now, if you don’t want to mess with selling short, you have another course of action: buy put options. They let you place a small bet for the chance to make a big return if the price of a stock drops.
Check out my article from last Friday about how to select a strike price for more guidance.
Editor, Apex Profit Alert