ETF Talk: Do You Have Nerves of Steel?

The strength of steel is so renowned that it often is used metaphorically to describe unwavering soundness. At the same time, steel is a key input in the manufacturing of cars, buildings and household appliances.

As the economy starts to recover, the price of steel could climb along with demand from fast-developing countries like China and India. Indeed, a shift in market sentiment in favor of steel already may be occurring. A sharp rise in demand for the metal during the last month may be a signal that the time has arrived to consider investing in a steel exchange-traded fund (ETF). However, the decision is not an easy one. The investment case for steel is not nearly as sturdy as the metal itself.

Here’s a brief assessment of the current situation to help you make your choice. Commodities have been trending upward since last summer when the sector took a big hit. Of course, no sector escaped the sharp teeth of the ferocious bear market back then.

Downturns in the housing and automotive industries — both big users of steel — caused the demand for the metal to weaken almost overnight. Steel companies cut production drastically last year as prices slumped from their record highs of mid-2008. As a result, Market Vectors Steel ETF (SLX) dropped 67% last year.

However, the steel market may have finally bottomed out. A big reason is China’s increasing demand for steel. The country accounts for 35% of global steel demand and its government recently injected $585 billion in stimulus money into its domestic economy. As the world’s largest user of steel, China may help to lead the sector to a recovery. Indeed, China’s loan and infrastructure investments are rising 27% annually. Credit Suisse analysts took notice and recently boosted their investment rating on steel to "overweight." China’s rising demand for the metal caused SLX to jump nearly 50% since the March 9 rally.

However, there still is reason why you may want nerves of steel to invest in this metal. Despite China’s strong demand for steel, many analysts fear that higher Chinese export subsidies may undercut global prices. In fact, outside of China, worldwide steel output is down 37% from last year.

If you ask me, there is much riding on the export and spending decisions of the Chinese government. When conventional market forces are circumvented by government policies, predicting which direction an investment will go becomes more difficult. Personally, I am holding back on investing in this sector right now.

If, however, you are convinced that Chinese demand for steel will drive both production and prices up, then a long position in SLX gives you a chance to profit. If you prefer to wait and see what China actually does, holding off on investing in SLX might give you a more restful night’s sleep.

As always, I am happy to answer any questions you may have about ETFs. To send a question for me to address in a future ETF Talk feature, please click here.