Seismic Shifts and Contrarian Thinking

“Extraordinary Popular Delusions and the Madness of Crowds” is a history of popular folly authored by Scottish journalist Charles Mackay. According to Wikipedia, the work was first published in 1841.

MacKay’s subject matter cast a wide net across philosophical and economic boundaries. Of particular interest to economists, are the popular delusion theories devoted to economic bubbles. And that too is a broad landscape, as there are many sub-theories around the role herd mentality plays in the creation of bubbles.

For our purposes, thoughtful traders might want to cast a spotlight on some of these peripheral themes, which read like a handbook for contrarian thinking. For example, if everyone is bullish on a particular stock, is it time to take profits? Can one buck upward momentum on the basis that, logically, an overwhelmingly bullish crowd have already staked a position, and therefore, who is left to buy?

What we know with certainty, is that markets driven by momentum, eventually bump up against an “intrinsic value” wall. The point at which prices can no longer be supported by logic. We can avail ourselves to a snapshot of these events in hindsight only. Defined on a stock chart by a synchronized spike in price and volume.

Unfortunately, when such seismic shifts occur, they can be very painful to the pocketbook. Witness the 25% sell-off in silver last week! Arguably, when you consider the simultaneous decline in gold, oil, and the general malaise in the commodity market, last week may well have marked the beginning of the end of a commodity cycle.

And yet, despite that, there remains an army of bulls who feel compelled to catch a falling knife. All of which provides a speculative opportunity for contrarian thinkers.

On a stock specific basis, I would draw your attention to Teck Resources Ltd. (TSC: TCK.B, Firday’s close $48.80). Teck is a major Canadian resource company (last year’s net income was $1.5 billion), that produces and ships coal and copper.

Not surprising, there are an army of Canadian analysts who follow Teck. And last month, the analysts shared, almost overwhelmingly, bullish optimism for the stock. Some in fact, had become increasingly bullish month over month. Of the 19 analysts who follow Teck, 15 rated it a “buy” or “strong buy.” Their logic involves a continuing belief in the sustainability of demand for coal as the primary energy source for steel fabrication from emerging economies… particularly China.

Any notion of a reality check has come from Teck management, who, since the beginning of the year, have been guiding earnings lower. Explaining… logically, Teck’s 20% decline in share price since January.

Still, analysts see this decline as a temporary phenomenon, owing to interruptions in copper production in Chile, coal output in B.C., labour problems at its Fording Coal operations, and delays at shipping terminals.

Clearly, the emerging market demand story is plausible, and longer term may provide the pay off analysts are expecting. But right now, there is a rush to the exits in all commodities. Coal and copper are no exceptions.

A rush to the exits will continue to impact Teck’s earnings this year. And the last time I checked, momentum driven by optimism, eventually gives way to the relationship between earnings and stock price.

If you are one who takes overwhelming analyst bullishness as a contrarian signal, and believe that we are witnessing a rotation out of commodities, there may be more downside to come. On that basis, buying puts on Teck could deliver some decent profits.

Look at the June 48 puts at $2.35 as a short term trade. The maximum risk on this trade is the cost of the puts, which would occur if Teck closed at, or above, $48 per share at the June expiration (the options expire on June 18th). This trade is for nimble investors who should be willing to sell half their stake at any point where a decent profit can be booked.

Another way to trade a seismic shift scenario is with bear call spreads. In fact, this may be a better strategy, as the Teck options are relatively expensive. June options on Teck are trading at 38% implied volatility which is in the top quartile of all Canadian options.

A bear call spread could be implemented by selling the June 50 calls at 1.90 and buying the June 56 calls at 50 cents. The maximum profit on the bear call spread is the $1.40 net credit received (i.e. $1.90 less 0.50 = $1.40). The maximum profit occurs if Teck is below $50 at the June expiration.

The maximum risk on this trade is $4.60 per share, which would occur if Teck closed above $56 at the June expiration. The advantage here, is that Teck does not have to fall further, and in fact could stay the same or rise slightly, and still produce the maximum profit.

On the other hand, if you own the stock and presumably like the longer term potential of the emerging market demand story, you must be willing to accept short term downside momentum as nothing more than a pullback within a longer term uptrend.

In that scenario, you might want to write covered calls to capture income while continuing to hold the shares. Selling say, the Teck June 50 calls at $1.90 per share.

The risk is that you lose your shares if the stock is above the $50 strike price at the June expiration. The potential is to gain increased income should the stock remain below $50 at the June expiration.