How Low Can Materials Stocks Go?

If you�re looking for evidence that materials stocks remain a dangerous place to bottom-fish, look no further than Monday�s market action in AK Steel (NYSE:AKS).

The stock was hit with two analyst downgrades over the weekend, one of which came from Goldman Sachs (NYSE:GS). Goldman whacked AKS with a sell rating and a $5 price target, citing no fewer than five reasons for its call: weak steel prices, �no sign of a turnaround� in AK Steel�s end markets, and the company�s enormous level of debt, rising capital expenditures and high pension funding requirements.

Investors Singing the Stock Split Blues

None of the headwinds cited in the Goldman Sachs report should come as a surprise to investors, and this sort of analyst activity often is the sign of a near-term bottom in a stock. Still, there are two key takeaways from the selloff in AK Steel.

First, AK Steel�s meltdown shows that no matter how far stocks in the materials sector already have fallen, there still is plenty of potential for further downside. AKS collapsed 14% on Monday — falling right to Goldman�s new target in just one session — even though the stock entered the week already down more than 64% from its early July peak.

This is important because, on the surface, so many materials stocks look cheap right now. Some well-known names, such as ArcelorMittal (NYSE:MT), Southern Copper (NYSE:SCCO) and Vale (NYSE:VALE), are trading with dividend yields that are equal to or higher than their forward price-to-earnings ratios. The trouble, of course, is that the outlook for Europe makes any analysis of value to be virtually meaningless right now.

While policymakers have succeeded in �kicking the can down the road� for more than two years now, the potential for a calamity appears to be growing. If a worst-case scenario does in fact occur, materials stocks still have a long way to go to reach their trough valuations of the last crisis in 2008. What�s more, the extent of the current downturns for the majority of stocks in the sector is nowhere near the 80% to 90% haircuts many received in 2008.

The technical picture supports the bearish case, as a number of industry bellwethers are flashing warning signals. US Steel (NYSE:X) broke support to hit a new 52-week low on Monday, while Alcoa (NYSE:AA), Mosaic (NYSE:MOS) and Freeport McMoran (NYSE:FCX) are close to doing the same. In all cases, the stocks are moving into territory where they haven�t traded since early 2009 — indicating there is little support below their current levels. The most recent leg of the downturn in the Market Vectors Coal ETF (NYSE:KOL) illustrates the potential danger of ignoring a move below multiyear lows right now:

The second key takeaway from the AK Steel downgrade are the subsequent questions about whether the company can remain solvent — a going concern given its $1.1 billion of debt on $42 million in cash. In a vacuum, rumblings about bankruptcy of a company the size of AK Steel might not mean much. However, this comes just weeks after similar worries crushed the shares of Patriot Coal (NYSE:PCX). This type of news is exactly what you want to see if you�re not already invested in these sectors because it signals capacity destruction and the possible elimination of peripheral players. Both developments are hugely positive for the survivors in the long term.

Unfortunately, this theme is unlikely to play out for quite some time. For now, news from the public sector remains the key driver of performance. It�s true that news on this front might actually be positive: Any signal that QE3 is on the way is likely to drive massive short-term gains in the most depressed areas of the materials sector. Still, the bottom for the materials sector could be a long way off if Europe proves to be the source of more bad news in the weeks ahead.

As a result, the higher-beta materials stocks have become a binary option on government policy. And for individual investors, this is a bet that�s unsafe at any price.

As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.