Loonie Strength Not Likely To Continue

There are few considerations for a strengthening U.S. Dollar which will inevitably push commodity prices lower and the Loonie along with it.

  1. Economic issues abroad remain unresolved
  2. U.S. Economy remains the “lessor of all evils”
  3. Continued divergent monetary policy foster a “race to the bottom”
  4. Possible U.S. rate hike

European and Japanese economies continue to weaken and while the U.S. isn’t perfect, it is doing OK. Countries will try to stimulate growth in their economies by implementing monetary policy that essentially weakens their currency and makes it “cheaper” on a global scale to do business with them.  Given the economic state of Europe, Japan and many other nations, having their currencies strengthen will be catastrophic to their economies as they won’t be able to handle the resulting deflationary forces.  It is my belief that while the U.S. is not going raise interest rates, Europe and Japan will have to act to reverse the strengthening of their currencies in order to save their economies.  As a result, the U.S. Dollar will strengthen not because of the action (or inaction) of the U.S. Central Banks, but because of the actions of others.

So what does this mean for the Canadian Dollar?

CAD has strengthened because of a recovery in commodities,  most notably oil, due to the weakening of the USD.  Since commodities are priced in U.S. Dollars, as the currency increases, commodity prices decrease and vice/versa.  Note in the chart below the correlation between commodities in general, oil and the CAD (etf FXC) and the inverse relationship to the U.S. Dollar Index.  In addition, it is not out of the realm of possibility that we see another Bank of Canada rate cut.  Poloz even suggested back in December that if things got really bad, we could see negative interest rates in Canada.  Unlikely, yes…but he did mention it.

Daily chart  5/25/2016 - U.S. Dollar Index compared to TSX Composite, CAD, Oil and the U.S. Commodity Index

usd compare

It is my expectation that global central banks will do everything in their power to weaken their currencies in an attempt to stimulate their economies and that a strong Euro/Yen etc. is unsustainable without having a significant negative impact on their respective economies.  The U.S. simply just has to maintain their current interest rate policy and the other central banks will be the catalyst for a USD snap back.  Although a weak USD is good for their economy, the world is in a currency war (good book by the way) and it’s a race to the bottom. Based on this expectation, We will likely see a “correction” in the commodity market on the heels of a strengthening USD.  We are already seeing the trend change in the USD/CAD chart as indicated below. I suspect that once we finally see oil rollover this trend will only strengthen.

Daily chart 5/25/2016 - USD/CAD

usd_cad

So with all this in mind how do we participate?

I am a firm believer that if you can keep it simple, do it.  Based on our bullish USD/CAD outlook, we could buy USX call options.  The purchase of the call option allows us to participate in the appreciation of the USD against the CAD with a limited and identifiable risk exposure.  These options are European style exercise and are cash settled for the difference between the settlement value and the strike price.  You can close your position at any time prior to expiration to cut losses and lock in profits.

Option premiums are quoted in Canadian cents per unit of foreign currency. For example, a premium quotation of 0.75 Canadian cents for an option on the U.S. dollar represents an aggregate premium value of 0.75 Canadian cents / US$ × US$10,000 × C$1/100 Canadian cents = C$75.

For more information please check out USX specifications here.

Which contract?

If we believe that the USD is likely to continue to trend higher for an extended period, we would want to be sure to give the opportunity time to play out.  In addition, choosing a longer dated option will also allow us to weather some of the bumps along the way.  Since I am suggesting a bullish outlook, we would want to use a Long Call to participate.

Option Type: Call
Strike: 130
Expiration: January 2017
Price: $5.00
Break Even: USD/CAD at $1.35 on expiration

Note that a more advanced trader may want to consider a Bull Call Spread to reduce the cost and break-even point of the position.

In conclusion, trying to forecast the moves of central banks and the impact on a specific currency can be challenging.  Often, central bank decisions and the subsequent impact on the market proves to be far from logical.  That said, participating as an option buyer allows us to take a decisive directional bias with a limited and identifiable risk exposure.  This this strategy can also be implemented in a TFSA or RRSP.

Playing Defence with Cash Secured Puts?

I have a love hate relationship with Canadian financial institutions. Canadian banks are tough competition for someone in the money management business. As an investment however, they are well capitalized – more than can be said for many European banks – and pay healthy dividends, which are bumped up on a regular basis. Or and did I mention, the big six Canadian banks are “too big to fail!”

Canadian insurance companies are also interesting although their performance has lagged the banking sector in recent years. Canadian insurers are mature beasts with virtually zero domestic growth prospects. A fact that has existed in the marketplace for years. The only domestic strategy for Canadian insures is to capture market share from competitors. Basically a zero sum game!

If that were not enough try pricing insurance contracts in an ultra-low interest rate environment. Not to mention annuities and casualty insurance where short term interest rates have remained near zero.

In the search for growth the largest insurance companies are looking beyond Canada. Manulife for example, continues to make inroads into Asia, particularly Singapore, China and Viet Nam. But given the size of Manulife analysts doubt it will have any serious near term impact on the bottom line. Certainly not the kind of market moving impact growth investors want.

The real impact for banks and insurers will come from higher interest rates. Banks because it will have a marked impact on their margins and insurance companies because they can earn a better return on their invested capital.

In the interim traders should look to this sector as a haven for low volatility blue chip stocks that pay healthy dividends. And while this may not be exciting, in the current environment it is an excellent defensive sector for your portfolio.

In the case of National Bank (TMX: NA, Friday’s close $42.0, dividend yield 5.139%) and Manulife (PMX: MFC, $17.90, 4.134%) traders might want to look at a writing cash-secured puts.

Since options take into account the spread between the risk free interest rate and dividends paid by the underlying company, the at-the-money puts on both NA and MFC are trading at much higher premiums that the same strike calls.

Traders who like the yield on National Bank might look at writing the NA October 42 puts at $2.50 per share. Set aside $39.50 out of pocket plus the $2.50 premium as capital to buy the shares should the short put get assigned. Assuming NA closes above $42 per share in October, your five month return on invested capital is 6.32%. If the shares fall, you will have to buy in at $42 less the $2.50 premium for a net cost of $39.50 per share. At $39.50 net cost the stock yields 5.47% which means, you might think about taking the shares and collecting the dividend.

With MFC, look at writing the January 18 puts at $1.60 per share. Set aside $16.40 out of pocket plus the $1.60 premium as capital to buy the shares should the short put get assigned.

Assuming MFC closes above $18 per share in January, your eight month return on invested capital is 9.75%. If the shares fall, you will have to buy in at $18 less the $1.60 premium for a net cost of $16.40 per share.

The Montréal Exchange Introduces Options Trading Ideas

The Montréal Exchange welcomes a new contributor, Alan Grigoletto, to its experienced and knowledgeable lineup of experts! Please find his first options trading idea on When to exercise call options to collect the dividend?

Happy reading!

Gold Covered Straddles

I talked about gold… reluctantly, back in February. I also read with interest comments from Patrick Ceresna who, also in February, penned a two-part thesis on why gold should move higher. And Patrick provided some strategies for investors to take advantage of his bull case which, I might add, have paid off handsomely.

I also penned a bull case… again reluctantly. And in the process chose a more conservative approach. If you followed our lead in February, you should be quite happy. If you are not happy because you thought a more aggressive strategy would have produced a better payoff well that’s a negative behavioral issue that you might want to reassess. But enough about investing psychology.

The debate at this stage is whether gold stocks, which have risen in percentage terms significantly more than bullion, are in the early stages of a longer term uptrend or have they been the beneficiary of a short term blip caused by a secular rotation into precious metals. It is an interesting question which I will leave for those who have more insight into the world of gold aficionados.

For those who want to play the gold card but share my reservations about jumping on an emotional roller coaster, consider employing the covered straddle as a way to enter the game. I have talked about this recently when looking at volatile elements within the market. And for gold stocks, volatility is the one factor that exists with certainty.

To that point, it is interesting to note that gold stocks tend to be more volatile on the way up. That is diametrically opposite to what we see in other sectors where volatility rises when stocks fall. The covered straddle takes advantage of this anomaly.

The idea is to buy an underlying gold stock and write a call and put on the shares. If gold stocks rise – in keeping with the longer term uptrend thesis – the shares will be called away and you would have captured two option premiums trading at above average implied volatilities.

If gold stocks decline – in keeping with the secular rotation thesis – you would be able to average into a position at a more reasonable price point. Probably averaging down your cost base to prices that existed prior to the recent surge.

To make this case I will look at a couple of examples. Obviously feel free to apply the strategy to your favorite gold stock because the numbers will look similar to the following examples.

With that in mind let’s examine Goldcorp and Barrick Gold as case studies. Arguable two of the more poorly run gold companies.

With Goldcorp (TMX: G, Friday’s close $24.78), we will buy 500 shares and write the October 24 calls at $2.55 and October 24 puts at $3.35 for a net credit of $5.90 per share. If Goldcorp stays the same or rises by the October expiration your shares will be called away at $24 per share. The October 24 puts will expire worthless and your six-month total return on invested capital (I assume you would use margin to carry the short put) will be 20.7%.

If Goldcorp is trading below $24 at the October expiration you will be required to buy another 500 shares at $24 per share. The short calls will expire worthless. The average cost for 1,000 shares at that point would be $21.44 which is about where Goldcorp was before gold took off.

Barrick Gold (ABX, Friday’s close: $23.83) produces similar results. Buy 500 shares of ABX and write the ABX October 23 calls at $3.35 and the ABX October 23 puts at $2.50 generates $5.55 in premium income. If ABX stays the same or rises the six-month return on invested capital is 19.6%. If ABX declines the calls will expire worthless but you would be obligated to buy an additional 500 shares at $23. Your average cost for 1,000 shares would be $20.66. That’s above the price at which ABX was at in mid-March mainly because ABX had a stronger rally related to company specific issues. But it still passes muster when considering you are a late entry into the gold story.

Stepping Into Energy

Is the energy market becoming energized? It is a tough question laden with ambiguity. Evidenced by reams of well thought out research where slight changes in the inputs can shift the bias from bull to bear and back again.

Interesting the foundation for most of the research concentrates on output. How much supply OPEC and non-OPEC producers are expected to bring to market! The challenge is that this dataset is volatile and fraught with political bias.

What we do know is that 1) supply is outstripping demand and 2) OPEC will continue to maintain output at a level that will rein in competition both inside OPEC (i.e. Saudi Arabia vs Iran) and across non-OPEC regions (i.e. Russia and North America).

What we don’t know is 1) where oil prices will go in the short to medium term and 2) whether small to medium sized Canadian companies can survive at the US$40 per barrel price point.

Investors wanting to trade aggressively in this space need to understand that normal influences between supply and demand have given way to political grandstanding. Which is to say the energy market is drifting in some very rough waters.

For aggressive traders wanting to increase exposure within the energy space, think about short to medium term strategies. Work with the underlying volatility by dollar cost average your way into a new position.

With that in mind let’s re-visit a strategy talked about a couple of weeks ago (see “Bombardier Covered Straddles,” April 18, 2016). The goal is to implement covered straddles using a couple of small to mid-sized energy names. With the caveat that you should be willing to own the underlying shares for up to a year as the position matures.

The first name is Crescent Point Energy (TMX: CPG, Friday’s close $21.14) which yields 1.70% because of a monthly distribution of 3 cents per share. To highlight the risk associated with this sector consider that CPG was paying a monthly distribution of 23 cents per share in July of last year.

According to the TMX Money website, Crescent Point Energy Corp is involved in acquiring and holding interests in petroleum and natural gas properties and assets related through a general partnership and wholly owned subsidiaries.

With CPG you could look at buying the shares at $21.14 and writing the in-the-money July 20 calls at $2.15 and at-the-money July 20 puts at $1.05. The combined premium from the sale of the call and put is $3.20 per share.

The short calls obligate you to sell your shares of CPG at $20 per share until the third Friday in July. If CPG remains the same or rises it will be called away at the $20 strike price. The eleven week return assuming the stock is called away is 15.14%.

If CPG closes below the $20 strike price in July the CPG July 20 puts will be exercised and you would be obligated to buy an additional block of shares at $20 per share. At that point you would own twice as many shares as were initially purchased and your average cost for the CPG shares would be $18.97.

The second name is Precision Drilling (PG, $6.51). This is a small cap company that does not pay a dividend. The company provides drilling equipment for oil companies in Canada and the US and specializes in providing onshore drilling services in conventional & unconventional oil & natural gas basins in Canada and United States.

The PD straddle works much the same way as you would buy the shares at $6.51 and write the PD July 6 calls (90 cents per share) and PD July 6 puts (38 cents per share) for a total net premium of $1.28 per share.

If PD is above $6.00 per share by the third week in July the calls will be exercised and you would deliver your shares to the call buyer. That would complete the trade. The eleven week return from the sale of the shares is 19.66%.

If PD closes below the $6 strike price in July the PD July 6 puts will be exercised and you would be obligated to buy an additional block at $6 per share. At that point you would own twice as many shares and an average cost of $5.62 per share.

By selling the straddles we as using volatility to establish a low cost initial position with excellent return potential. At the same time we are instituting a mechanism to average down the cost base should the market decline over the short term.

Evaluating Earnings Variability

We often hear about the expected movement in a stocks’ share price based on an upcoming earnings release. Calculated as an implied trading range by reverse engineering the option pricing formula.

Traders typically use some version of the Black Scholes option pricing model to calculate the theoretical fair value for a call and a put on the underlying stock. Inputs such as time to expiry, current stock price, strike price, risk free rate of return, expected dividends payable by the underlying stock and of course, volatility. The latter input being the variable – i.e. best guess – within the pricing model.

Reverse engineering involves plugging the option price into the formula and asking it to solve for volatility. This output is the option’s implied volatility which is to say, what volatility input is required to generate the current price for the option. When analysts tell us that an upcoming earnings release could move a stocks’ price up or down by 10% they are basing that comment on the implied volatility calculation.

An easier way to arrive at the similar analysis without having P.H.D. in mathematics is to look at the current price of the near term at-the-money straddle on the underlying stock. A straddle involves the simultaneous purchase or sale of a call and put at the same strike price with the same expiration date.

A straddle buyer wants the underlying stock to move far enough to cover the cost of both options. The seller of a straddle wants the underlying stock to trade within a range bounded by the total premium of the call and the put. With either approach the trader is making a bet as to expected volatility prior to the options expiry. Neither is a directional bet on where the underlying stock is expected to trade.

To bring some perspective to this discussion let’s look at the expected price range for a stock where there is an impending earnings release. For example, BCE Inc. is reporting earnings next week. The consensus estimate for quarterly earnings is 85 cents per share.

BCE Inc. is a large blue chip company with a long history of paying and more importantly, increasing quarterly dividends. As such the earnings estimates provided by analysts tend to be clustered in a tight range. Very different from say, a company like Teck Resources that is also reporting next week.

To calculate the projected price range for BCE Inc. based on the upcoming earnings number we would look at the near term (i.e. May expiration) at-the-money straddle. BCE closed Friday at $58.48, so the closest at-the-money strike is $58.00. Based on Fridays numbers the BCE May 58 call was trading at $1.05 with the BCE May 58 put at $0.55. The total value of both options is $1.60 per share.

The next step is to add the total cost of the straddle to the strike price so that we have an upside target of $59.60. If we subtract the $1.60 from the strike price we end up with a downside number at $56.40. That is the expected trading range of BCE between now and the May expiration which in percentage terms, is a range of 2.736%. Quite low based on the expected earnings number.

Applying the same math to Teck Resources (TMX: TCK.B) where there is a rather large spread in the expected earnings data we get a much different picture. TCK.B closed Friday at $13.17 per share which makes the May 13 strike the best match to come up with a possible trading range.

The TCK.B May 13 call was trading at $1.40 with the TCK.B May 13 put at $1.25. Total cost for the two options is $2.65 which gives us a trading range of $10.35 and $15.65. In percentage terms that is a 21.121% trading range between now and the third Friday in May.

As we are well into first quarter earnings season option traders can play this variability where the payoff will depend on whether the company matches, beats or misses their EPS expectation.

Strategically companies do their best to guide analysts’ to a reasonable expectation. The objective is to guide estimates to the lower end of a range so that management can beat expectations. Easier for management to take a congratulatory lap rather than trying to explain a failed quarter.

Of course many factors are beyond the control of management. The sharp decline in oil prices being a recent case in point. The variability of gold prices and commodities in general being another factor.

On the other hand, companies like Thompson Reuters and BCE Inc. have relatively stable earnings streams allowing managements to provide guidance that is more often than not within basis points of the end number.

The options market is very good as calculating just how variable quarterly earnings might be. This can be useful information for investors looking to implement a new position, hedge risk into an earnings release, or to speculate on whether the company is likely to hit or miss on guidance.

With that in mind here is a list of companies who will release earnings this week. I have included the consensus earnings number as well as the implied trading range based on May at the money options.

Stock Price Range Percent At-The-Money
Symbol Price Up Down Range Calls Puts Strike Est.
TCK.B $13.17 $15.65 $10.35 20.121% 1.40 1.25 13.00 -0.09
PD $6.00 $6.78 $5.22 13.000% 0.40 0.38 6.00 -0.15
AEM $52.39 $57.10 $46.90 9.735% 2.75 2.35 52.00 -0.03
ABX $20.41 $21.68 $18.32 8.231% 1.05 0.63 20.00 0.09
HSE $18.05 $19.45 $16.55 8.033% 0.75 0.70 18.00 -0.23
G $21.65 $23.66 $20.34 7.667% 0.66 1.00 22.00 0.03
CVE $19.24 $20.43 $17.57 7.432% 0.83 0.60 19.00 -0.38
POT $22.72 $24.66 $21.34 7.306% 0.70 0.96 23.00 0.23
SU $36.30 $38.03 $33.97 5.592% 1.18 0.85 36.00 -0.22
SJ $46.56 $48.25 $43.75 4.832% 1.45 0.80 46.00 0.51
CU $35.05 $37.65 $34.35 4.708% 0.20 1.45 36.00 0.62
TRI $51.70 $54.30 $49.70 4.449% 0.85 1.45 52.00 0.60
CNR $83.45 $87.30 $80.70 3.954% 1.40 1.90 84.00 0.93
BCE $58.48 $59.60 $56.40 2.736% 1.05 0.55 58.00 0.85

Hedging Hope

Those that regularly follow my articles and forecasts can easily ascertain that I am a worry wart.  Fortunately, or unfortunately I am always skeptical on overly optimistic views on stocks and the economy.

So what am I skeptical on now?

I am skeptical on the supposed turn around in the Canadian economy. Yes, things have improved over the last quarter, but I simply do not think that the fuel for this turnaround is sustainable. The global economy has extraordinary challenges ahead of it, which is likely to act like a cold wet blanket on the recent hot commodity market. Yet, traders and investors are looking at the January lows as the end of the commodity bear market and have been buying in sheer madness, driven by the fear of missing a perceived bottom.

This entire cycle is predicated on HOPE.

Hope that the worst is over in China, hope that Europe remains stable, hope that the U.S. does not fall into a recession, hope that global demand for commodities begins to manifest itself.

I ask- what if this “HOPE” is just wishful thinking?

Personally, I want to hedge that hope. It is not about panicking or shorting the markets, it is more about recognizing that this rally may not have the underlying fundamentals to support a sustainable expansion.

So what can we do?  Protect oneself.

Let’s look at an example. I want to focus on Canadian banks with an example using Royal Bank.  The Canadian banks have had a great start to the year.  Royal Bank has traded as low as $64.00 in January and has now recovered $14.00 from its lowest levels and is now pushing new 52 week highs at $78.00 a share.  This financial recovery has occurred at the same time as many European, Chinese and Japanese banks face extraordinary headwinds and many U.S. financials that still remain well off their previous highs.  These Canadian banks are somehow trading like we are in the midst of a new commodity bull market and that all of the risks from energy company loan defaults have somehow been averted.

In this example, we have an investor that owns 1,000 shares of Royal Bank and is focused on dividends and longer term appreciation.   After having experienced the $14.00 rise in share value over the last 3 months, this investor is looking to hedge the downside risk and lock in recent gains.  So what can our investor do?

  • Investor owns 1,000 shares of Royal Bank valued at $78,000.00
  • Investor buys 10 June 17th $76.00 put options
  • The options are asking $1.10 (April 29th 2016)
  • The investor pays $1,100.00 for the puts ($1.10 x1000)

What has the investor accomplished?

By having spent some of their profits on buying the puts, they have secured a guaranteed sale price of $76.00 per share over the next 6 weeks.  If the investors’ concerns of a drop are unfounded and Royal Bank shares continue to rise, the investor still owns the shares and has 100% of the upside. Alternatively, if the market reverses and heads lower, the investor has a protective put that removes all downside risk below $76.00 between now and June 17th.

Some buy and hold investors are willing to expose themselves to unconstrained downside risk, but personally I always feel most comfortable being invested knowing that the risk is managed and the worst case scenario has been hedged.

A Bombardier Covered Straddle

There is little doubt that Bombardier (TSX: BBD.B, Friday’s close $1.62) is on life support. At issue is the diagnosis. Does the company follow in the footsteps of Blackberry to survive as a shadow of its former self? Or does the company collapse under a mountain of debt and litigation in much the same way as Nortel?

Unfortunately, no one knows which is why Bombardier is not a stock for long term investors. However, the BBD class B shares have options and under the right conditions there may be short term opportunities for aggressive speculators.

What we do know is the Bombardier is caught in the middle of a fierce tug of war between bulls and bears. The company manufactures excellent products with a solid market in Canada. Not so much in other parts of the world. Particularly when it comes to subway trains and executive planes.

Despite the problems Bombardier class B shares are up more than 100% since mid-February when they hit an all-time low of $0.72. Some might say this is simply a bounce from a longer term bear trend… although bounces do not normally end with tripe digit advances.

Bulls might argue that Bombardier is a turnaround story! Although not many would take a long term stake expecting to see a return to better times. More likely they are hoping the company wins enough contracts to remain viable.

That latter point is critical. A viable Canadian manufacturing company based in Quebec providing good paying private sector jobs carries a lot of political currency. Is it possible that the Federal government and Quebec Legislature might look at Bombardier as politically, if not systemically, important?

What we have then is a low priced stock with available options and no discernable long term trend. Makes an interesting case study for a short term covered straddle. I say that because holding BBD.B shares while selling both calls and puts with the same strike price and expiration date is a volatility trade; not a directional trade.

For example, you could buy say, 1,000 shares of BBD.B at $1.62 per share while selling the BBD.B May $1.50 calls (trading at 25 cents per share) and BBD.B May $1.50 puts (trading at 14 cents per share). The sale of both the calls and the puts will net you 39 cents per share in premium income. The long stock covers the short calls while cash or margin secures the obligations attendant with the short puts.

This is a short term speculation with an expiration date in just over a month. At the May expiration, either BBD.B shares will close above or below $1.50. If BBD.B shares are above $1.50, the puts will expire worthless and the calls will be exercised. At which point you deliver your BBD.B shares to the call buyer. Under this scenario the one-month return is 16.77% which occurs if BBD.B stays where it is, falls less than 12 cents per share, or rises.

If BBD.B shares close below $1.50 per share in May, the calls will expire worthless but you would be obligated to buy another 1,000 BBD.B shares at $1.50. Interestingly, the cost of the second block of shares is actually $1.50 per share less the 39 cent premium from the sale of the two options which results in a net cost for the second block of $1.11 per share. At this point the investor is holding 2,000 shares of BBD.B at an average cost of $1.365.

Either you earn a significant short term return or you end up with twice as many shares at a price significantly lower than Friday’s close. Which, by the way, is a real possibility and why this trade is best suited for aggressive traders.

What is a Reasonable Rate of Return?

There has been a lot of debate lately about the expected long term performance of equity markets. It comes down to a simple question; what is a reasonable rate of return? To paraphrase Bob Dylan, the numbers; they are a changing!

Ask most investors and they will tell you that double digit returns are possible, if not probable. And while that view may turn out to be correct it is certainly not supported by return data since the turn of the century.

For example, the iShares S&P/TSX 60 Index Fund (TMX, symbol XIU) has, on a price basis, returned approximately 0.791% per annum from its high in early September 2000. If you add back dividends the numbers are better with an approximate compound return of 3.15% over the same period.

With all due respect to the industry wide caveat that historical performance is not necessarily indicative of future performance, one cannot ignore long term trends if doing so results in unrealistic expectations. And the previous 16+ years of data comes nowhere close to investor expectations about future growth!

So… what’s reasonable?

Reasonable assessments begin with an assessment of the economy in terms of its potential and pitfalls. Because the Canadian economy is influenced by exports to the US the potential and pitfalls are one in the same. The performance of the US economy goes to our benefit and detriment. And while the US economy may be the best house on a bad street, it is certainly not a pretty picture.

I am not suggesting the Canadian economy is bed ridden. Quite the opposite as the numbers are pointing to stronger growth. However we cannot escape the fact that we operate between a rock (central bank largesse) and a hard place (a tepid global recovery). The implication is tepid growth for Canadian GDP likely between 1.0% to 2.0% rather than the 2.5% to 3.5% range that approximates historical norms.

The objective is to build an investment thesis that mimics toned down growth expectations. To that point investors might want to re-think the role dividends play in a portfolios’ total return. I suspect dividends will become ever more important in terms of total return. And if you believe as I do, that a more realistic return assessment is somewhere in the mid-single digits, then mature blue chip dividend paying stocks should anchor the portfolio.

If we add option writing to this discussion the combination of dividends and premium income should deliver returns in the mid-single digits while at the same time reducing portfolio risk.

Case in point is the Enbridge Income Fund Holdings Inc.* (TMX, symbol EMF, Friday’s close $29.49). EMF operates pipelines on behalf of Enbridge Inc. (TMX; symbol ENB) who owns 50% of the fund. Think of EMF as a toll road for oil and natural gas. The fund distributes monthly income to unitholders based on the tariffs to transport gas through the pipeline. It currently pays 15.6 cents per unit per month which equates to a 6.33% yield that we believe is sustainable.

EMF also has options. The EMF October 30 calls are trading around $1.10. If you write the October 30 calls at $1.10 the six month return if exercised is 5.4%. Add back six monthly distributions and the return pops to 8.6%. Return if unchanged is 3.72%, ex-distributions, and 6.9% including distributions. Downside breakeven taking into account the dividends is $27.46.

In this case we have an example of a company where there is a high probability of ending up with a return in the mid-single digits without requiring a larger than life upside move.

In my view… a reasonable rate of return!

* Full disclosure, clients of Croft Financial Group own positions in the Enbridge Income Fund.

Has the Tide Turned for the Canadian Economy?

The last two months have dynamically changed the narrative toward the Canadian economy. Over those two months, the markets have substantially shifted, including:

  • 15% rise in the Canadian Dollar from its $0.68 lows to its current levels around $0.78.
  • 27% rise in oil prices from their lows below $30.00 to around $38.00 today.
  • 16% rise in the TSX60 from its 680.00 lows in January to its current levels at 790.00
  • 36% rise in the Canadian Energy stocks based on the iShares S&P/TSX Capped Energy ETF (XEG).
  • Canadian GDP numbers for January came in at 0.6%, double the 0.3% forecast.
  • Canadian Real Estate in Vancouver and Toronto continue to accelerate with strong demand at record levels.
  • The Federal stimulus package is expected to give the Canadian economy a boost and diversify the economy away from being commodity centric.

So everything is ok, right? Thumbs up, time to go long Canada, EH!

The picture may not be so rosy when this is all put into context.  Let’s tackle the bullish points one at a time.

First off, the Canadian dollar rally has to be put into context of the prior decline. The decline in 2015 was one of the single most significant and steep declines in the Canadian dollar since the 2008 financial crisis.  After such extremely oversold conditions, the current rally is just modestly retracing the prior weakness.

Similarly, when looking at oil, after a decline from $120 down to under $30, this rally can categorize as proportionally underwhelming.  Even a 50% retracement of the 2015 decline should have seen oil rise to above $50.00 a barrel.  If broader weakness persists, further pressure will continue on many of the mid-tier oil producers as many companies are burning heavy cash flows at current levels.

Much of the rise the Canadian stock markets was driven by a broad rebound in commodity stocks and financial banks.  There are plenty of risks that this may be short lived.  There remains a global economic slowdown that will keep the rise in commodities in check.  At the same time, the global banking sector remains heavily challenged in Europe, China and increasing in the U.S.  In that light, Canadian banks still disproportionately rely on energy financing and real estate for their revenues. While both energy and real estate are stable for now, where is the future growth engine going to emerge?

In regards to the economy, the January GDP numbers had a big boost from the weak dollar, which now has rebounded. Will the strengthening dollar weaken future numbers?  Obviously many turn to the Federal stimulus package as a further driver of growth, but many experts are skeptical suggesting that the federal budget could still fall short of delivering a meaningful pick-up in growth.

From our perspective, there are plenty of reasons to still consider hedging some of the risks.  Utilizing option overlay strategies such as protective puts, collars and index option hedging are all very attractive, particularly during this period where the implied volatility in the markets has declined making it more affordable to implement.