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The U.S. housing market recovery has been under way for the past year, but analysts believe there could be a lot more upside when considering how much the sector fell. While mortgage stocks and homebuilders are the most popular plays on sector, timber recently entered the limelight in 2012. However, many analysts remain divided on its potential in 2013.

Bull Case: Timber's Recovery is Only Recent

Timber's performance over the past five years has lagged that of both residential mortgages and homebuilders, according to data from Google Finance. While timber entered the limelight in 2012, the commodity remains priced at relatively low levels given the growth in homebuilding, and only slightly greater than the growth seen in residential mortgages.

Five-year comparison:

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One-year comparison:

(click to enlarge)

These charts suggest that timber may still be lagging in relation to residential mortgages and homebuilders when looking at a longer time horizon. With the strong performance (and projected performance) of the U.S. housing market, timber prices may continue to move up and eventually catch up with the performance seen in these other areas.

Bear Case: Potential Risk in Lumber Supply

Timber is unlike many homebuilders or mortgages in that there's always the potential for an increase in near-term supply regardless of actual demand. Production at timber mills is expected to ramp up in Canada, as shifts move from 40-hour to 50-hour weeks, according to a recent article in Bloomberg News that cited Forest Economic Advisors LLC, which could jump supply figures.

Lumber demand from China also appears to be ebbing in recent months. During the first quarter, lumber exports from the U.S. fell 16%, after experiencing strong growth over the past three years. While some of this may be due to higher lumber prices - up 27% so far this year, slower demand will still have an impact on the prospects of price appreciation moving forward.

According to Shawn Hackett, president of Hackett Financial Advisors Inc., "We are heading for a tremendous crash in the lumber market. We've gotten way overdone to the upside. This is the time to be a bear."

Looking for Dividend Plays in Timber

Timber ETFs like the iShares S&P Global Timber & Forestry ETF (NASDAQ:WOOD) and the Claymore Beacon Global Timber ETF (NYSEARCA:CUT) offer easy plays on the sector with small dividend yields. But, the opportunities in the sector may be individual timber equities offering stronger dividend yields in an attractive income-investing environment, particularly if they come down a bit from their highs.

With the U.S. Federal Reserve considering the end of quantitative easing, investors are increasingly seeking out equities in lieu of bonds. Equities that offer dividend yields may be preferable in these cases, particularly with speculation of a dividend tax hike from the fiscal cliff leaving many dividend stocks still relatively undervalued.

Plum Creek Timber Co Inc. (NYSE:PCL) is one such timber stock that investors may want to consider, with a 3.63% dividend yield, while Weyerhaeuser Company (NYSE:WY) represents another option, with a 2.24% dividend yield, using prices from January 9, 2013. While these stocks trade with lofty TTM P/E ratios, forward multiples are significantly lower given enhanced earnings. Although, investors may want to wait for the two to come off of their 52-week highs before taking a position, or start to average in over time.

Use Options to Hedge or Bet on Timber

Investors may also want to consider using stock options to help hedge their long positions against downside. Covered call options represent a common way to reduce a position's breakeven point over time and reduce overall risk. Moreover, this strategy provides a regular income in exchange for sacrificing only potential upside.

Unfortunately, the increasingly bearish outlook on the sector has led to low call premiums and somewhat high put premiums. Investors may want to consider purchasing protective puts right now and then moving into covered calls if/when sentiment becomes more bullish and call premiums begin to rise to more reasonable levels. But, even puts remain expensive, as many are seeking protection.

Instead, bullish investors may therefore want to consider simply purchasing call options in lieu of equity, given that the premiums remain relatively low. At the money PCL 45 JAN 14 LEAPS are trading with an ask price of 3.35, meaning that investors can purchase the rights to the stock anytime between now and January 17, 2014, with a breakeven price of $48.35 and an investment of just $335.

Source: The Great Timber Debate (And How To Play It)