With speculation growing about the possibility of an economic slowdown, some readers may be surprised at these new recommendations by contributing editor Tom Slee. But read what he has to say before making up your mind. Tom holds both CFA and CGA designations and managed pension money for many years.

Tom Slee writes:

Base metals have had an amazing year. Every one of the primary products has been strong. Nickel and zinc prices doubled and copper has soared almost 90%. No wonder the TSX Metals and Mining sub-index is up a staggering 36% since last December despite a recent correction. It has been an extraordinary run, so spectacular that you have to wonder whether the party is over. Is it time to cash in? My feeling is no. This base metals bull still has legs.

Let me say at the outset that these stocks are not for the defensive or nervous investor. They are volatile, constantly reacting to world events, and at the moment there is a sharp division over where prices are going. The respected Bank Credit Analyst in Montreal feels that commodity demand is easing as economies cool. U.S. analyst Paul van Eeden is more blunt. He believes that these are dangerous times for metals speculators because hedge funds have driven prices out of sight. As a result, Mr. van Eeden sees two threats: the inevitable reaction after a run-up and an economic slowdown.

The bears have a case and certainly copper and zinc prices are off, down about 8% since early August. It’s also likely that traders using base metals as a hedge against the U.S. dollar will become net sellers now that the greenback has stabilized. Against this, though, we have to weigh the fact that we are in the midst of a major, secular commodities bull market, the first since the 1970s. Metal prices may fluctuate, even dip sharply over the short term, but there is a rising tide.

The simple truth is that world demand for basic commodities is outstripping supply. In previous shorter cycles, whenever base metal prices started climbing, producers reactivated marginal mines and flooded the market. That is no longer possible. We certainly have huge undeveloped resources but it is going to take time and money, lots of money, to bring these on-stream. What has changed? India and China ! They are now enormous consumers and the Central Eastern European countries, tasting prosperity, are also spurring demand. As one commentator pointed out, there are nearly 2.5 billion more people on the planet since the last commodities bull 30 years ago and as infrastructure grows there is an increasing competition for limited resources. In many ways it’s a somber outlook. It’s also an encouraging backdrop for Canadian metals stocks.

Please don’t misunderstand. I am not saying that commodities are a license to print money. As small investors, we have to keep this market in perspective. The long-term trend is positive but prices are going to ebb and flow as demand fluctuates and right now the crucial U.S. economy seems to be losing steam. Caution is the word. However, even in the short term fundamentalists, as opposed to traders, are positive.

For example, Adam Rowley of Macquarie Bank, an acknowledged expert on international metal prices, is upbeat. Speaking at a recent base metals summit in Mumbai, he said that raw materials were tight and likely to remain that way, alumina and zinc concentrates in particular. Bellwether copper supply may match demand in 2006 but only just. Most important, Mr. Rowley pointed out that demand growth is accelerating across the board. Zinc is in deficit while aluminum and nickel are no more than balanced for the moment.

He went on to say that China ’s voracious appetite now dominates the markets. China accounted for 20%-30% of overall world demand in 2005 and, even allowing for a slowdown, will consume well over 30% of global production by 2010. As a result, base metal prices are expected to remain above historical levels at least to the end of the decade.

Closer to home, Canadian analysts are scrambling to adjust for the surge in metal prices and increasing their already optimistic 2006 and 2007 earnings forecasts. One leading brokerage house has raised its metal prices projections by 40% for this year and feels that the overall bull market, already a record 59 months long, is likely to continue for the foreseeable future.

Tumbling my own numbers, I discovered that this upward trend has not only been in place for five years but has been almost uninterrupted. For instance, measured in U.S. cents per pound, copper was 75 in 2001 and has climbed steadily to 249 this year. Nickel was 294 in 2001 and has increased each year to 721, and so it goes. This is no longer a highly cyclical sector. There is strong, consistent support.

At the same time, we have to keep one important technical factor in mind. Some of the base metal price increases are due to huge, unprecedented purchases by the investment funds. According to reports at the Mumbai conference, there was approximately US$80 billion invested in commodity index funds at the end of 2005, up from less than US$30 billion in 2003. We may see US$100 billion by the end of this year. Is this the ticking bomb some people fear? Possibly, but I see the fund participation as a sustaining rather than a destabilizing factor.

First of all, this professionally managed money has been systematically committed to the sector. These are not speculative investments designed for a short-term ride. Also, the managers are undeterred by the record prices that we have seen this year. The money keeps coming. I think that means the funds will provide a floor. They are going to stay as long as the fundamentals remain good. Sure, the hedge funds are going to raid the commodities and their related stocks from time to time but most of the leading institutions are in for the long haul.

So there is the case for buying metals stocks, but which ones? My preference is the aluminum industry, for several reasons. In the first place, the major companies, with their consumer exposure, are less of a raw commodities play. Second, the fundamentals are excellent. China could produce 11.7 million metric tons this year but even so the industry expects a net deficit between global supply and demand of 300,000 tons in 2006. Incidentally, observers have noticed that Chinese officials now consistently overstate their country’s supply numbers in an effort to shake out hedge funds and reduce the price they pay for imports. That 11.7 million tonnes may not stand up.

Aluminum prices averaged US85c a pound last year and touched US$1.35 a pound this summer, the first time we have seen these levels since 1988. With demand growing at 5.1% per annum while supply is increasing 4.1%, we may see US$1.50 a pound by year-end. Only a significant global economic slump would take the starch out of aluminum and nobody is forecasting that. In fact, The Economist, a respected business publication, expects a serious aluminum shortage out to mid-2007 and probably beyond.

Amongst the companies, I like Alcoa and Alcan, both for the same reasons. They are solid, well diversified, and generating strong earnings growth while their stocks remain relatively cheap. At current levels, the shares provide buying opportunities for investors seeking capital gains who are able to assume some risk.

 

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ALCAN ALSO LOOKS GOOD

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Alcan (TSX, NYSE: AL ), although it’s difficult to believe, actually started life as the Northern Aluminum Company, a subsidiary of Alcoa. Spun off in 1928, the company realized that it could not compete in North America and successfully expanded abroad. Today, largely through acquisitions, Alcan is the world’s second-largest integrated aluminum company primarily focused on its alumina, metal ingot, engineered products, and packaging operations.

Here again, we have a well-diversified international giant. The company is active in 60 countries, has sales of about $25 billion (again, all amounts are in U.S. dollars since Alcan reports financials in that currency), assets in the $27 billion range, and a market capitalization close to $17 billion.

Recently, because of its Canadian base, Alcan has been hurt by the soaring loonie and increased energy costs have squeezed margins. Even so, second-quarter results were impressive. The company reported a profit from continuing operations of $554 million, or $1.48 a share, up significantly from 71c a year ago. At the same time, Alcan increased its quarterly dividend to 20c a share.

All of the business groups did well except Packaging, where profit was down 24% year-over-year as a result of higher raw material and restructuring costs. Management expects this group to show a sharp improvement in the third quarter. We are also seeing pre-tax synergies and savings of roughly $400 million a year from the acquisition of Pechiney in 2003.

Looking ahead, Alcan is poised to benefit from a 40% interest in the new Alouette smelter and the expansion of its Gove alumina refinery in Australia . Earnings of $6.25 a share are expected this year with an increase to the $9 range in 2007.

I realize that this call may seem like an about-face from my sell recommendation last October at $38.38 when investors were disenchanted with aluminum. Since then, however, several things have occurred. The anticipated oversupply never materialized and prices, instead of dipping to a forecast 73c a pound (on their way to 64c) have soared. Most important, aluminum stocks are back in favour. I think that it is time to get back aboard

Action now : Buy Alcan at C$43.32 (US$38.93) with a target of C$60 (US$54). I will revisit the stock if it dips to C$40.

- end Tom Slee

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YOLA EDWARDS ON THE VACATION OPTION

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Contributing editor Yola Edwards is also with us this week with an options strategy that offers the possibility of decent profits with limited risk. It’s a little complicated and you may need to read it a couple of times to grasp all the fine points, but it offers a way to make money even when the stock markets are going nowhere.

Yola Edwards writes:

In the August update, I suggested that the Dow Jones Industrial Average, then registering 11,266, was in oversold territory, despite having risen 6% since my July update. I anticipated that it would head toward 11,826 by October. With the index having registered a high of 11,650 in September it appears that we are well on the way to the target.

At the same time, I suggested that the TSX at 12,056 was overbought and investors should buy the dips as the future remained bright. I suggested an aggressive two-month target of 12,700 to 13,000. As the recent correction has taken longer than expected, my timing has been extended to anticipate the target level being reached by year’s end or just into 2007.

While others have been warning of a severe decline, I finally have some company in the bullish camp. On Sept. 18, UBS Securities Canada Inc. increased its 12-month target for the S&P/TSX Composite Index by 4% and advised its clients to move more of their money into the stock market. In doing so, the firm cited “a continued strong earnings outlook.”

However, regardless of the health of the economy or the general market direction, securities move at their own pace and in their own direction: up, down, or sideways. So investors may wish to consider utilizing option strategies to lock in profit or reduce risk.

To employ option strategies, you must open an option account and a margin account. Speak to your investment advisor before venturing into options to assure yourself that they are suitable for your portfolio.

Simply defined, options are wasting assets. You may have heard of people losing their shirts who play options and indeed it can be a risky game if you’re simply betting on a directional move without any protection. Last week’s headlines about the billions lost by the Amaranth Advisors hedge fund on natural gas prices will attest to that.

However, utilized properly, options can help reduce risk and increase profitability by helping you navigate the market. They enable you to maintain a greater degree of control over your investments by responding to existing market conditions rather than waiting for an upturn or downturn. The chart below depicts the more popular option risk management strategies best suited to meet an investor’s anticipated price movement.

If options are something you’re considering, then one strategy that you might find interesting is the so-called “vacation option”. A successful vacation is being able to relax while getting the most for your money in the little time you have available. The so-called vacation trade – also known as the time, horizontal, or calendar spread – utilizes the same principles and would be employed if you anticipate that a particular stock, or the market, may trend sideways or, in other words, may be range bound. With another holiday season around the corner, it’s something to think about.

A horizontal calendar spread is one that uses calls or puts with the same strike price but different expiry dates. It is viewed as a short-term neutral strategy, but is generally longer-term bullish or bearish as investors typically use a slightly out-of-the-money (OTM) strike price, which in turn assumes the bullish or bearish bias through to the expiration of the first option. A neutral market position would use at-the-money (ATM) or slightly in-the-money (ITM) options. The position is created by purchasing a longer-term option and simultaneously selling a shorter-term option with the same strike price.

Vital to the success of the option vacation strategy, or calendar spread, are time and time decay, with time value being eroded faster on the short-term option then the value of the long option at the end of the trade. The aim is to sell short-term call or put options with higher implied volatility (IV) and buy longer-term call or put options with lower implied volatility, paying as little a debit as possible.

In the event the short option expires worthless, the investor can sell another near-term option with the same strike price to create a second calendar spread if their outlook is still short-term neutral or sell an option with the same expiration but different strike price to create a vertical spread if a more modest directional move is expected. Alternatively, the investor can simply remain long the further-out option if the outlook is more bullish or bearish.

The key to successful calendar spreads is to be able to roll forward to capture more time premium, eventually erasing the initial debit and create a credit in the account. Do not leg onto a spread, meaning do not try to execute the orders separately, as you are then exposed to any sudden adverse market movements. Always enter it as a spread order with the strike prices and months and the desired debit spread limit. The investor must realize also that there are times when t hese strategic order entries may not actually be able to be executed due to market forces.

Calendar spreads are limited risk positions with unlimited reward potential to the upside for the call calendar and limited risk but high potential reward to the downside for the put calendar. Calendar spreads are purchased in a margin account, but no margin requirement is necessary because, theoretically, the purchased option has a longer life than the written option and should the short contract make an adverse move and be assigned, the investor can exercise the long contract, thus purchasing the underlying stock at the same price at which it was called away and exit the strategy. Since the strike prices are the same, the total risk is limited to the initial debit paid when creating the calendar plus any commission costs.

To get a sense of the underlying stock’s option value on you could use the option calculator found on the CBOE website at http://www.cboe.com/TradTool/IVolMain.aspx

Let’s look at a calendar spread example using Applied Materials Inc. (NDQ: AMAT), which has been range-bound predominantly in the $15.50 - $17.80 range since August 2004 (figures in U.S. dollars). In the short term, the stock is overbought as it traded at $17.38 on Sept. 20 and appears vulnerable to a pullback to about $16 over the next month. The closest neutral options are for October 2006 and April 2007.

For illustrative purposes, we would sell the Oct. 17 calls at 75c and buy the April 17 calls for $2.05 for a net debit spread of $1.30 excluding commissions. If the stock is $16.99 or lower in October, then the near-term option would expire worthless and you could sell either the Nov. 17 call option or go further out.

Of course, if the stock goes above the $17 strike price, then the stock will be called away and you would exercise the longer option to deliver the shares. Your loss would be the initial $1.30 or $130 per contract plus any applicable commissions.

However, for illustrative purposes, let’s assume that the short option expires worthless. The CBOE option calculator indicates that the stock option’s short-term implied volatility (IV) is 26.18% with 31 days to the October expiry, while the April 2007 contract has 202 days to expiry and has a 30.12% IV. If the stock remains in the $17 range with the same IV through to the first expiry in October, then using a Black-Scholes calculator found on the CBOE link above, we could assume that the value of the April 17 option with 183 days to expiry when the October options expire would be worth about $1.61. Thus you would automatically be in a net credit position of 31c or $31 per option as there are 100 shares associated with each option contract.

You could then either sell the longer-term option or roll forward, selling the next nearest contract or one further out. We can speculate, using the Black-Scholes calculator, that at the October expiry, all things being equal, the Nov. 17 call option with 28 days to expiry at that point could be worth about 60c. The Dec. 17 option, with 43 days, would be worth 75c cents and the Jan. 17 call with 78 days to expiry could be worth about $1. The Feb. 17 call, with 94 days to run, could be worth $1.12 and so on, giving the investor additional possibilities to roll forward depending on their outlook.

Another popular use of the calendar spread is to generate income, similar to a covered call strategy. This involves buying LEAPS (Long Term Equity Anticipation Securities) instead of the actual stock. This strategy requires selling calls against the LEAPS instead of the actual stock. This is done because the LEAPS can be purchased much more cheaply than the actual stock, which can generate much higher returns on invested capital. The risk with this implementation is that the underlying stock goes down in price instead of staying neutral, causing your LEAPS to go down in value. If, on the other hand, the underlying stock goes up in price at the expiration of the near-term option (instead of staying neutral), you could buy back the option you sold and then sell another option, one or more months out.

As you can see there are a myriad of permutations and combinations to be had to structure a neutral portfolio using options. It just requires more research on the investor’s part. Investors may wish to paper trade to get a feel for how this works before venturing into the strategy.

Though the calendar strategy takes place over a longer period of time then a normal vacation, you are essentially in control of a low risk, stress-reducing strategy, which can be closed out at any time that you elect. It needs very little of your time and energy to maintain, and can earn you a handsome profit over time.

- end Yola Edwards

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YOUR QUESTIONS

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Investing cash

Q – This may be of general interest to IWB readers, given that many of us aren’t afraid to be cash hogs these days. My broker wants me to switch my RBC T-Bill fund to the Manulife Investment Savings Account Fund, which he advises offers the same benefits as this fund. It is liquid and accessible the next day, the unit value does not change, and there is no cost to buy or sell, just like the RBC T-Bill Fund. The current rate of the Manulife fund is 3.85% whereas the RBC T-Bill Fund is only 2.40%. Good advice? – Bill H.

A – As I have mentioned in the past, several companies now offer high-yield cash accounts with trailer fees to make them attractive to both financial advisors and investors. This is just one choice; others include Altamira Cash Performer and the new Dundee Investment Savings Account which also has a 3.85% rate (or 4.10% if held in a fee-based account).

In terms of current yield, these accounts are far superior to money market funds and in fact threaten their very existence. All money funds have MERs, often in the 1% range, which puts them at a huge disadvantage. Since the securities they hold lag the market, their yields will always be below those of high-interest accounts when rates are rising. However, if rates fall suddenly, a switch to a money fund might be in order because the yield on high-interest accounts will plummet as well. A money market fund will take longer to reflect a declining interest rate environment – that will happen more gradually as maturing notes are rolled over.

So to answer your question directly, yes, it’s good advice. – G.P.

 

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MEMBERS’ CORNER

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