Risk Aversion Trade a good buy

Posted by Ryan Irvine - Keystone Financial

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Market BuzzRisk Aversion Trade Will Provide Opportunities Long-Term

Just ahead of Toronto’s Group of 20 nation’s summit, the TSX ended up in another volatile session. For the week however, four of the five sessions ended down as worries about the fragility of the global economic recovery hit financial markets.

Again, investors pulled back a bit from riskier assets this week as evidence builds that economic growth, particularly in the United States, may be slowing. This has combined with fears that the spending cuts and tax raises being promulgated by European governments to cut debt will hurt the recovery.

Today, the G8 leaders meeting in Toronto — turning into the G20 on Saturday – gets set to grapple with this issue with Washington warning against cutting too far and too fast.

At some point however, the slumps have to be taken and a period of zero to minimal growth with austerity should be observed and is likely needed. Whether the politics of the day will allow this (or our leaders will be strong enough to go forward with this type of policy, particularly in the U.S.) remains to be seen.

With the acceleration of the European debt crisis worries, a renewed focus on U.S. debt, concerns about the removal of government stimulus over the next several months and the risk aversion trade has produced jittery markets over the past two months. For a number of Toronto-listed China-based stocks we cover, including big names like forestry plantation giant, Sino-Forest Corporation (TRE:TSX) (a company we have recommended since 2002 when it traded at $1.15), these jitters have been compounded by questions of a home grown housing bubble and slack export demand.

The combination has produced a sell-off in this segment with Sino-Forest dropping from its 52-week high in April of $21.75 to recently hit $16.00.

The concerns are not without merit. But, we have heard similar criticism and skepticism on China since we began looking at the region (via North American listed companies) as a viable segment to uncover growth stocks just over a decade ago. Each time, over the long term, the skeptics have been proven wrong and we have been very pleased with our returns from buying a basket of profitable companies operating in this market (in combination with a diversified overall portfolio).

LooniversityYour Options

With the markets continuing to follow a volatile downward trend, option investing (particularly in puts) has become a hot topic. As a result, we thought now would be an excellent time for a brief primer on options.

There are two basic types of options: calls and puts.

A call gives the holder the right to buy an asset (usually stocks or indices) at a certain price within a specific period of time. Calls are very similar to having a long position on a stock. Buyers of calls hope that the stock will increase substantially before the option expires, so that they can then buy and quickly resell the amount of stock specified in the contract, or merely be paid the difference in the stock price when they go to exercise the option.

A put gives the holder the right to sell an asset (usually stocks or indices) at a certain price within a specific period of time. Puts are very similar to having a short position on a stock. Buyers of puts are betting that the price of the stock will fall before the option expires, thus enabling them to sell it at a price higher than its current market value and reap an instant profit.

It should be noted that an option gives the holder the right to do something; you are not required to exercise if you do not want to or if the terms are not favourable.

Put it to Us?

Q. I am a recent viewer of BNN and just becoming familiar with the financial “lingo.” A couple terms have me scratching my head – “Big Board” and “Forward Earnings.” Please help.

– Harry Bell; Calgary, Alberta

A. While the popularity of networks such as CNBC and BNN have brought the “wacky” world of investing to the masses, we often find many commentators forget they are in most cases talking to a viewing audience that has yet to receive their Masters in Finance.

The term “Big Board” is simply a nickname for the New York Stock Exchange. Founded in 1792, the NYSE is the oldest exchange in the United States and more than 2,000 common and preferred stocks are traded on it. Back in 1792, the trading floor was under a buttonwood tree. Nowadays, this area is known as Wall Street.

“Forward Earnings” refers to analyst forecasts used in the context of a P/E ratio based on forward (expected) earnings rather than on the trailing earnings (latest 12 months), which is quoted more often. Remember, forward earnings are nothing more than predictions made by analysts and thus, are by no means guaranteed to be accurate.

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