Does the Steel Industry Perform Differently Than the Basic Materials Sector?

Does the Steel Industry Perform Differently Than the Basic Materials Sector?

By C. Michael Carty, Edward Matluck, Ph.D., and Andrea Psoras  (authored in late 2006, early 2007)

  1. Executive Summary

The purpose of this paper is to present the results of research that compares the steel industry and basic materials sector.  In the past, investors wishing to manage their exposure to the steel industry have had to either purchase steel stocks, basic materials exchange-traded funds and/or mutual funds.  Recently, Van Eck’s Market Vectors – Steel ETF (SLX) was launched which eases this task.  We find that this ETF performs differently from those based on basic materials indices.  More specifically, a steel index consisting of domestic stocks and foreign ADRs and ADSs is found to possess distinct characteristics relative to broader basic materials indices. Although these sectors can move together, they often diverge from each other. An investment tied specifically to a steel industry index therefore offers more direct ways of gaining or reducing portfolio exposure to that industry, giving professional and private investors greater flexibility in separating economic and market trends specific to it from those influencing other sectors and the overall market.

In order to demonstrate the existence of these distinguishing characteristics, this study investigates the historical stock market performance of the Amex Steel Index (STEEL) used in the Market Vectors – Steel ETF, the Dow Jones US Basic Materials Index (DJUSBM) underlying the iShares Dow Jones US Basic Materials Sector Index Fund (IYM) and the S&P Materials Index (IXB) underlying the Materials Select Sector SPDR Fund (XLB). Since historical data for the indices are not of sufficient length to encompass several economic and market cycles, they were reconstructed using their rules of construction as closely as possible going back nearly 30 years. Standard statistical tests were conducted to determine their monthly and annual returns, standard deviations, correlations, betas, maximum draw-downs, draw-down durations, tracking errors relative to the S&P 500 index, and relationships to macroeconomic data and cyclical patterns.

On the basis of this evidence, we conclude that the Amex Steel Index underlying the Market Vectors – Steel Fund is distinguishable to a statistically significant degree from the basic materials indices underlying the iShares Dow Jones US Basic Materials Sector Index Fund and the Materials Select Sector SPDR Fund.  The primary implication of this conclusion is that broad basic materials indices, by being diversified across a number of basic materials industries, obscures the steel industry’s unique performance characteristics.  Therefore, investors interested in gaining or reducing exposure to the steel industry should do so directly by using an ETF based on a steel index instead of one based on a basic materials index, all other things being equal.

 

  1. Background

The common stocks of the steel industry and basic materials sector trade differently and are not proxies for one another. One reason is that they diverge somewhat in the underlying fundamentals that govern supply and demand.  Key drivers or end markets of steel include autos and parts, oil services, commercial construction, capital goods production, and defense related expenditures.  Other basic industries are tied to different end product markets; e.g., aluminum is tied very closely to aerospace, chemicals to processing markets, forest products to residential construction, and paper throughout the economy.

In addition, union and labor issues differ completely as do many of the sources of profitability.  Marketing and sales strategies also differ as do seasonal patterns.  On the other hand, both steel and the basic materials sector overall are sensitive to economic activity and demand patterns are often similar.

Because capital intensity as well as manufacturing capacity differs among these industries, their component companies sell at different price-to-earnings multiples and betas, and trade with different cyclical patterns.  Including all these companies in the same index obscures the movements of their individual industries and thus fails to identify various profit opportunities.  For example, when steel stocks are cheap, other basic materials’ stocks may be relatively expensive.

Starting in July 2003, operating margins in steel went from around 7% to 20% in September 2005. Since then, they have begun to recede and are now around 15%. Over the same period, basic materials’ operating margins have fluctuated in a narrow range, between 13% and 18% and are now about 17.5%.  It is likely that higher steel operating margins resulted from higher prices related to import quotas and tariffs to which basic materials’ operating margins did not respond. Subsequently, lower steel prices related to eliminating quotas and tariffs caused operating margins to recede. On-again off-again protectionist measures by the government over the past 50 years further contributed to differentiating the steel industry’s performance from that of basic materials.

 

III. Trading Opportunities with ETFs

ETFs have become a generally accepted tool for specific investment strategies, sector rotation, hedging and risk control.  Despite the popularity of sector ETFs, many are little more than aggregates of a number of industries having different characteristics.  For example, a number of ETFs already exist for the basic materials sector, i.e., iShares Dow Jones US Basic Materials Sector Index Fund, Materials Select Sector SPDR Fund, PowerShares Dynamic Basic Materials Sector Portfolio (PYZ), PowerShares FTSE RAFI Basic Materials Sector Portfolio (PRFM), streetTracks SPDR Metals and Mining (XME), and Vanguard Materials ETF (VAW).  However, SLX is the only ETF specializing in the steel industry.

Different industries within a sector may be cheap or expensive at different times. Investors can take advantages of some of these relationships using the steel industry ETF.  For example, steel may become ‘cheap’ compared to non-ferrous metals which are subject to commodity market booms.  The ETF provides a way to buy the industry against those stocks and short it when things move the other way.  The basic materials sector which contains non-ferrous metals, chemicals and other non-metals based industries is too broad to allow this.

Commodities booms and busts in the steel industry have caused their stock prices to be more volatile than basic materials’. Steel industry stock prices rose 57.6% in 1980, 67.3% in 1987 and 63.0% in 2004, significantly in excess of basic materials’ stock prices. These spreads provided an opportunity for investors expecting steel stock prices to revert to the mean to liquidate their long positions, or adopt short positions.  Conversely, when steel stock prices were significantly below basic materials’ in 1982, 1984, 1986 and 2000, investors had the opportunity to either cover their short sales or acquire long positions.

The preferred investment at those times would be a diversified portfolio of steel stocks afforded by an index, not individual stocks which are subject to the specific risk associated with a single company.  Van Eck’s Market Vectors – Steel ETF provides a simple low cost means of acquiring or shorting the steel industry in a single trade.

In addition, investors often have a need to hedge their steel stock holdings. A well-diversified steel ETF is a valuable tool for such hedging.  Further, as trading in the ETF grows, futures and options based on the index could be offered, giving participants the opportunity to play spreads and hedge with limited risk instruments. (Currently, the Philadelphia Stock Exchange trades options on their steel index. However, this index contains only domestic stocks and may not be appropriate as a hedge for SLX.)

 

  1. Comparing the Steel Industry, Basic Materials Sector and the S&P 500

The Market Vectors – Steel ETF is based on the Amex Steel Index (STEEL), which is a modified capitalization-weighted index of common stocks or ADRs of publicly traded companies involved primarily in steel production. The number of constituents in STEEL and hence SLX will vary depending on a number of factors including trading volume and market cap.  There were 39 constituents in the index as of December 22, 2006.  Since there is no readily available long term history for most of the foreign issuers, prior history of the steel industry index had to be constructed without them.  However, one to two years of pricing data are available. The steel index was reconstructed using equal-weights for the constituents, as was the surrogate for both the Dow Jones US Basic Materials Index and S&P Materials Index.  The reconstructed is apparently a suitable surrogate for STEEL with a high 0.92 correlation to its monthly changes and a 0.98 correlation to DJUSST.

As of December 22, 2006, the iShares Dow Jones U.S. Materials Sector Index Fund is based on the Dow Jones U.S. Basic Materials Index, a float-weighted index containing 80 publicly traded companies involved in the diverse basic industries such as chemicals, forestry and paper, industrial metals and mining. The Materials Select Sector SPDR is based on the S&P Materials Index which is float-weighted index of 29 publicly traded companies involved primarily in such diverse basic industries as chemicals, forestry and paper, mining, non-ferrous metals, paper and steel.

Table 1 contains summary statistics related to the Steel, reconstructed Basic Materials and the S&P 500 Indices.  Over the period from January 1977 to August 2006, the Steel Index has a compound annual return of 12.32% versus 16.31% for the Basic Materials Index and 8.78% for the S&P 500. As one might expect, both the Steel Index’s 28.92% standard deviation and the Basic Materials’ 20.01% indicate their greater volatility than the S&P 500’s 8.78%.  Their betas, also a measure of volatility, are consistent with their standard deviations.  The Steel Index’s 1.27 beta is greater than the Basic Materials Index’s 1.08, and both are greater than the S&P 500’s 1.00. Somewhat surprising is the fact that the Steel Index has lower annual returns and higher volatility than the Basic Materials Index over the nearly 30-year period, which seems somewhat inconsistent with capital asset pricing theory, where one expects greater, not lesser, returns to be consistent with greater risk.

Table 1. Summary of the Statistical Results, January 1977 to August 2006

 

Steel Basic S&P 500
Index Materials  
Compound Annual Return (%) 12.32% 16.31% 8.78%
Annual Standard Deviation (%) 28.92% 20.01% 14.79%
Beta 1.27 1.08 1.00
Maximum Draw-down (%) -65.08% -28.16% -46.28%
Max Draw-down/Avg. Return. (Years) 5.3 1.7 5.27

Source: QED International Associates, Inc.

 

Further evidence of their unique characteristics lies in their maximum draw-downs over the period, and the times expected to overcome these draw-downs based on their average returns.  The Steel Index’s maximum draw-down is 65.08%, and would require 5.3 years to recover to its previous level given its average annual return. The Basic Materials Index’s 28.16% maximum draw-down is less than half of Steel’s and would require 1.7 years to recover on average.  The S&P 500’s unusually large maximum draw-down of 46.28% theoretically would require 5.27 years to recover, but it still has not achieved its former highest level.

The Indices’ compound annual returns since January 1977 and over 1, 3, 5, and 10 year periods ended August 2006 are shown in Table 2.  The annual returns of the Steel Index differ from those of the Basic Materials and S&P 500 Indices, further indicating a degree of independence between them. The individual annual returns for the indices are contained in the Appendix.

Table 2. Comparative Annual Returns of the Indices

Over 1, 3, 5, and 10 Years and Since January 1977

 

  Steel Basic Materials S&P 500
  Returns Returns Returns
1 Year 49.99% 25.71% 6.84%
3 Years 57.81% 21.38% 8.96%
5 Years 28.45% 18.08% 4.61%
10 Years 20.11% 24.20% 14.87%
Since Jan ’77 12.32% 16.31% 8.78%

Source: QED International Associates, Inc.

 

Chart 1. Growth in the Value of $100 Invested in the Steel, Materials, Basic Materials and S&P 500 Indices, January 1977 to August 2006

Source: QED International Associates, Inc.

Assuming initial investment of $100 is made in each of the three indices in January 1977, the terminal values of those investments at the end of August 2006 would be $3,136.83 in Steel, $8,842.85 in Basic Materials and $1.213.31 in the S&P 500.  These results clearly indicate the Steel, Basic Materials and S&P 500 Indices perform differently with regards to returns.

The results in Chart 1 indicate significant differences regarding terminal and intermediate values in returns of the Steel, Basic Materials and S&P 500 Indices. For example, in April of 1998 both the Steel and Basic Materials Indices peaked, while the broad market as measured buy the S&P 500 continued to climb. The Basic Materials Index bottomed out in September 1998, while the Steel Index continued to falter.   After finding ‘bottom’ in February 2003, it rose more rapidly than both the Basic Materials and S&P 500 Indices.

Chart 2. Annual Returns in the Steel, Basic Materials and

S&P 500 Indices, January 1977 to August 2006

 

Source: QED International Associates, Inc.

The results in Chart 2 further substantiate significant differences in the Steel, Basic Materials and S&P 500 Indices.  At times their returns move together, often catching the same turning points, but occasionally moving in different directions. Steel outperformed Basic Materials in 13 of the 30 years, and the S&P 500 in 17 years.  In some years, such as 1982, 1986, 1994 and 1996 the Steel Index had negative returns while the Basic Materials Index had positive returns. In all but six cases, the returns between the two indices differed in magnitude.

The simple correlation of annual returns and tracking errors also indicates a statistical independence between the returns of these two indices.  Table 3 contains these statistics calculated over the nearly 30-year period, illustrating the existence of less than perfect correlations and significant tracking errors between the monthly returns of the Steel and Basic Materials Indices.  The evidence is all the more compelling when one recognizes steel, as a subset of the basic materials sector, is correlated perfectly with itself, having zero tracking error against its own index.

Table 3.  Correlation Coefficients and Tracking Errors for the Steel, Basic

Materials and S&P 500, January 1977 through August 2006

 

Correlation Steel Basic Mat’ls S&P 500
Steel 100.0%
Basic Materials 74.9% 100.0%
S&P 500 23.8% 54.0% 100.0%
Tracking Errors Steel Basic Mat’ls S&P 500
Steel 0.0%
Basic Materials 18.4% 0.0%
S&P 500 27.3% 14.3% 0.0%

Source: QED International Associates, Inc.

One might question whether the nearly 30-year steel index we constructed (QEDI Steel) is a proper surrogate for the Amex Steel Index (STEEL), or any other steel indices. Table 4 provides correlation and tracking error statistics comparing the reconstructed index with STEEL, the Dow Jones US Steel Index (DJUSST) and the S&P 500 between March 2001 and August 2006, a period common to all three. (S&P does not publish a steel index.) As evident in the table, the STEEL is highly correlated to the DJUSST and QEDI Steel with comparable tracking errors. In sum, the QEDI Steel Index appears to be a suitable proxy over the period common to STEEL and DJUSST. If STEEL had been computed back to January 1997, it would probably still be highly correlated to QEDI Steel.

Table 4.  Correlation Coefficients and Tracking Errors for Three

Steel Indices, March 2001 through August 2006

 

Correlation STEEL DJUSST QEDI Steel
STEEL 1.000
DJUSST 0.926 1.000
QEDI Steel 0.919 0.980 1.000
Tracking Error STEEL DJUSST QEDI Steel
STEEL 0.0%
DJUSST 16.5% 0.0%
QEDI Steel 17.9% 8.1% 0.0%

Source: QED International Associates, Inc.

 

  1. Summary and Conclusions

Although the steel industry is traditionally considered a subset of the basic materials sector, there are fundamental cyclical, economic and performance differences between it and other industries also considered to be basic industries. The end markets for the steel industry include autos and parts, oil services, commercial construction, capital goods and defense. Other basic industries serve other product markets. In addition, factor inputs differ substantially, iron ore and coke in steel, trees in forestry, wood and fiber in paper, etc. Even union and labor issues differ completely as do many of the sources of profitability.  Marketing and sales strategies also differ.

Because capital intensity as well as manufacturing capacity differs among these industries, their component companies sell at different price-to-earnings multiples and betas, and trade with different cyclical patterns.  Including all these companies in the same index obscures the performances of their individual industries and thus fails to identify various profit opportunities.  For example, when steel stocks are cheap, other basic materials’ stocks may be relatively expensive.

This study investigated the historical price performance of the Amex Steel Index underlying Van Eck’s Market Vectors – Steel ETF and the basic industry indices underlying the iShares Dow Jones US Basic Materials Sector Index Fund and the Materials Select Sector SPDR Fund.  Since historical data for the indices are not of sufficient length to encompass several economical and market cycles, they were reconstructed using their rules of construction going back nearly 30 years. Standard statistical tests were conducted to determine their monthly and annual returns, standard deviations, correlations, betas, maximum draw-downs, draw-down durations, tracking errors relative to the S&P 500 index, and relationships to macroeconomic data and cyclical patterns.

On the basis of this evidence, we conclude that the performance of the steel index underlying Van Eck’s Market Vectors – Steel Fund is distinguishable to a statistically significant degree from the basic materials indices underlying the iShares Dow Jones US Basic Materials Sector Index Fund and the Materials Select Sector SPDR Fund.  The primary implication of this conclusion is that a basic materials index, by being diversified across a number of industries, obscures the steel industry’s unique performance characteristics.  Therefore, investors wishing to gain or reduce exposure to the steel industry should do so directly with a vehicle such as Van Eck’s Market Vectors – Steel ETF instead of using basic materials ETFs.

January 4, 2007.

Appendix A.  Annual Returns to the Steel,

Basic Materials and S&P 500 Indices

 

       
Year Steel Basic Materials S&P 500
       
1977 1.23% 1.17% -11.50%
1978 28.88% 18.62% 1.06%
1979 41.08% 43.10% 12.31%
1980 57.63% 29.38% 25.77%
1981 7.31% 2.05% -9.73%
1982 -14.00% 16.85% 14.76%
1983 45.09% 40.98% 17.27%
1984 -25.06% -2.47% 1.40%
1985 13.30% 34.51% 26.33%
1986 -16.30% 19.81% 14.62%
1987 67.28% 37.36% 2.03%
1988 27.31% 28.54% 12.40%
1989 14.63% 22.69% 27.25%
1990 -10.50% -9.45% -6.56%
1991 37.76% 35.38% 26.31%
1992 31.85% 18.68% 4.46%
1993 28.23% 19.68% 7.06%
1994 -1.64% 8.00% -1.54%
1995 0.60% 16.23% 34.11%
1996 -3.71% 16.18% 20.26%
1997 1.12% 11.21% 31.01%
1998 -8.72% -2.40% 26.67%
1999 11.42% 17.89% 19.53%
2000 -35.04% -6.03% -10.14%
2001 23.13% 17.05% -13.04%
2002 -23.24% -5.01% -23.37%
2003 38.51% 39.71% 26.38%
2004 62.97% 22.18% 8.99%
2005 30.67% 7.48% 3.00%
2006* 25.82% 11.61% 4.45%

 

Source: QED International Associates, Inc.

* Data through August 2006

Appendix B. ETFs and Indices Discussed in this Study

  

Exchange-traded Funds Ticker
iShares Dow Jones US Basic Materials Sector Index Fund IYM
Market Vectors – Steel ETF SLX
Materials Select Sector SPDR Fund XLB
PowerShares Dynamic Basic Materials Sector Portfolio PYZ
PowerShares FTSE RAFI Basic Materials Sector Portfolio PRFM
streetTracks SPDR Metals and Mining XME
Vanguard Materials ETF VAW
Source: QED International Associates, Inc
Sector/Industry Indices Ticker
Amex Steel Index STEEL
Dow Jones US Basic Materials Index DJUSBM
Dow Jones US Steel Index DJUSST
S&P Materials Index IXB
Source: QED International Associates, Inc

  About QED International Associates, Inc (the firm was shut down just before the Lehman Brothers shut down in 2008).

Founded by Herbert Blank in 1997, QED International Associates, Inc. (QEDI) is a network of experienced quantitative investment professionals, who provide consulting services to the global investment community.

QEDI draws on its collective expertise to compose research studies and papers, development investment products, provide marketing advice, and design conference programs.  The QEDI focus includes asset allocation, exchange-traded funds, indexes, and risk management.  Recognized as a pioneer in ETF development, QEDI has played a key role in launching more than fifty ETFs traded across the globe.

About the Authors

  1. Michael Carty is Special Consultant to QEDI and is a recognized expert on exchange-traded funds and their strategic application, speaking frequently at major industry conferences about exchange-traded funds as lifetime financial planning tools and optimal ETF portfolio strategies. He has authored several articles on designing, understanding, and creating ETF investment programs, as well as developing and evaluating indexes for potential use as ETFs. He is also a principal of New Millennium Advisors, an investment advisory firm. Prior to that, he was Director of Closed-end Funds Research and Strategy at Prudential Securities, researching CEFs and evaluating potential IPOs. His academic background includes a Bachelor of Science degree in Industrial Engineering from the New Jersey Institute of Technology and a Master’s degree in Business Administration from Columbia University, where he also pursued doctoral studies

 

Edward Matluck, Ph.D. is Chief Executive Officer of QEDI in addition to serving as President of Hedgemetrics.  His work includes quantitative investing techniques, product development, and portfolio risk control modeling. He has 20 years experience in creating, developing, and marketing quantitative investment products and tools. Ed has significant experience in developing international and domestic equity indexes and creating index-based synthetic investment vehicles. Other specialties include economic forecasting and securities analysis.  Prominent firms in Ed’s career history include: APT, Inc.; DRI; Mosley Securities; Chase Manhattan: and Zacks Investment Research. His Ph.D. in Economics and Finance and a strong background in financial analysis and product development

Andrea Psoras, Senior Vice President for QEDI, is an established financial institutions and financial sector analyst, who has worked as an M&A (combinations, divestitures and related, private equity, “recaps”-bailouts engagements) investment banker on the execution side as well as an analyst on the counter-party credit risk side covering North American based financial institutions while consulting for one of the world’s largest banks.  Skilled in a variety of analytical disciplines-strengths, she is well informed (and on a number of commercial/industrial sectors) and knowledgeable of domestic as well as global economic and political subjects. Some of her former employers include KPMG, UBS Warburg, and Advest, and is Principal of her own consulting firm, Strategic Advisory. She also serves on 3 committees at the New York Society of Security Analysts and had earned her B.A. from Franklin & Marshall College.

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