Fortify Your Portfolio with Steel

01/26/2012 10:18 am EST


Thomas Aspray

, Professional Trader & Analyst

Materials stocks are outperforming the broad market, and bottom formations on two industry leaders and the primary sector ETF make them good buys for risk-tolerant investors.

The FOMC announcement on Wednesday appears to have ended the market’s very brief corrective phase, and the market internals were strong with over 2300 stocks advancing and just over 700 declining. This has pushed the Advance/Decline (A/D) lines sharply higher.

Some of the previously lagging market sectors are now showing signs of life. As further evidence that the economy is indeed getting stronger, new sectors are likely to become leaders (see “Sector Selection Is the Key for 2012”).

Last year was a rough one for many steel stocks, but even though many declined in value, there were some bright spots, including Steel Dynamics (STLD), which reported earnings that were much higher than estimates. The Select Sector SPDR - Materials (XLB) has completed a reverse head-and-shoulders bottom formation, as have the two steel stocks that I will recommend today.

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Chart Analysis: The Select Sector SPDR - Materials (XLB) closed above the neckline (line a) of its reverse head-and-shoulders (H&S) bottom formation at $36.30 last week. On Wednesday, XLB closed above last week’s high, which confirms the breakout.

  • There is resistance from last summer in the $40.20-$40.70 area with the measured target from the H&S bottom formation in the $44.50 area
  • The relative performance, or RS analysis, broke its downtrend, line b, in early 2012 and now looks ready to surpass strong resistance at line c
  • The daily on-balance volume (OBV) has confirmed the price action and now moved through its resistance at line d. It has just turned up from its weighted moving average (WMA)
  • There is initial support now at $36.50-$37 with stronger support at $35.50

AKS Steel Holding (AKS) reported a profit for the year but a loss for the fourth quarter. It retested the neckline (line f) on the news but gained over 8% on Wednesday. It is a very volatile stock and not for the faint hearted, showing a beta of 2.6.

  • The chart has strong resistance in the $13 area, line e, with the targets from the reverse H&S bottom formation also in the $13-$13.50 area
  • The RS line has completed its bottom formation by overcoming resistance at line g
  • The OBV did not make new lows with prices in October and shows a strong uptrend (line i). It is very close to breaking above the resistance at line h
  • Initial support now stands at $9-$9.40 with stronger support in the $8 area

NEXT: How to Manage Risk on High-Beta Steel Stocks


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United States Steel Corp. (X) is a $4.3 billion steel company set to report earnings on January 31. The stock closed solidly above the neckline (line a) of its reverse head-and-shoulders bottom formation on Wednesday.

  • The neckline is at $28.80 with the upside targets from the bottom formation in the $40-$41 area
  • The RS line has just closed above its resistance, line b, and has been in a shallow uptrend, line c
  • OBV formed a positive divergence at the October lows, line e, and has now overcome its long-term downtrend, line d
  • There is a band of good support between $27.50 and $29 with more important support at $25

What It Means: Though many of the material stocks have already done extremely well over the past few months, the improvement in the relative performance of the materials sector suggests this strength can continue.

Both of these steel stocks have high betas and as a result are suitable only for the high-risk portion of your portfolio. Initial stops will need to be a bit wider, but they can be tightened up once further resistance is overcome.

The Select Sector SPDR - Materials (XLB) is a lower-risk play and does have Nucor Corporation (NUE) among its holdings.

How to Profit: For the Select Sector SPDR - Materials (XLB), go 50% long at $36.88 and 50% long at $36.44 with a stop at $34.77 (risk of approx. 5.2%).

For AKS Steel Holding (AKS), go 50% long at $9.56 and 50% long at $9.24 with a stop at $8.08 (risk of approx. 14%). On a move above $11.50, raise the stop to $9.54.

For United States Steel Corp. (X), go 50% long at $29.04 and 50% long at $28.18 with a stop at $25.32 (risk of approx. 11.5%). On a move above $33.50, raise the stop to $29.54.

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