Dancing With the Cyclicals

 | May 21, 2013 | 9:00 AM EDT
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I have been struggling for several weeks to articulate how I feel about the current market. Equities seem to be getting away from economic fundamentals even as the market continues to relentlessly grind higher. Luckily, Doug Kass took the time yesterday to masterfully map out how he has been right on the economic fundamentals yet very wrong on the strength of the markets. If you have not read it (notation 1), I encourage you to take the time, it is well worth the five minutes.

My outlook and concerns are very similar to Doug's. I also think the Federal Reserve is "pushing on the string" right now and is very close to doing more harm than good with its current policies. Multiples have expanded significantly over the rally of the last seven months even as profits and economic fundamentals have not kept pace with rising stock prices. I personally believe the market is overdue for a significant correction (about 5% to 15%). However, a good investor always puts some money in play in case he is wrong; which unfortunately occurs all too often. As the saying goes, "You got to get up and dance as long as the music is playing."

I see two scenarios for the market right now. The market has a substantial setback sometime before the end of the year as the divergence between stock prices and their underlying fundamentals becomes too great. This could be the result of Federal Reserve "tapering" or a series of other possible negative events that hit the economy and/or the markets. I have a solid amount of cash on hand to buy on "dips" if this scenario plays out. I have also sold some of out of the money calls on some of my positions have shot up in the rally.

The other scenario is that the market is correctly anticipating a substantial improvement in the world economy. This will buoy demand and corporate profits and justify the run-up in equity prices. In this scenario, the beaten-down materials and mining sectors, which have substantially underperformed in this rally should have major moves upward.

One of the strategies I am using right now to gain exposure if this scenario plays out is buying long-dated bull call spreads on some cyclicals within the mining and material space. Given the low volatility/tiny option premiums available in the market right now, I think this play makes a lot of sense.

Let's take a look at how this would look in practice on a position I took on silver miner Hecla (HL) when the stock traded at $3.20 a share in early trading yesterday. Like most miners, Hecla has turned in a brutal performance so far in 2013. The shares were going for double the current price as recently as late 2012. However, the shares are incredibly cheap right now, trading at just 84% of book value and roughly 6x its earnings in 2011. The company has rapidly growing revenues, is still turning a profit and has an unencumbered balance sheet with significant net cash on the books. Its production is also in geopolitically stable North America. There are many scenarios I can model in which the stock will be trading much higher 12-24 months from now.

Therefore, I initiated 50 long-dated bull call spreads on the stock yesterday. I used the January 15 $4/$5 call pair to put this strategy into play. The cost for simultaneously buying the $4 calls and selling the $5 calls was $0.20 or $20 a contract. My total outlay was $1,000 plus commissions.

By initiating this option spread, I get exposure and significant upside on ~$16,000 worth of Hecla stock while protecting myself on the downside. If I am right and Hecla is trading above $5 in January 2015, I will pocket a profit of $4,000 minus commissions. This is an equivalent to a 25% gain on buying 5,000 shares of Hecla outright while my downside is limited to just $1,000.

I like this type of play as its preserves my capital to buy the market if it goes significantly lower while giving me exposure to upside should the market prove me wrong and continue to move higher. Investors who are looking for similar bull call spreads on other cyclicals should consider Freeport McMoRan (FCX) and U.S. Steel (X) among many other options.

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