New Trade – $BAC: American Idled

by Dan June 27, 2014 2:23 pm • Commentary

Bank stocks have lagged the broad market in 2014 as money-center and investment banks fend off of a whole host of challenges from increased regulatory scrutiny that appears to be resulting in no shortage of multi-billion fines, to dismal trading volumes, interest rates that won’t rise, low leverage ratios, declining mortgage activity, declining corporate buybacks and general capital markets activity that seems very near a top.  Add it all together, and the 70% year over year increase in earnings in Q1 for a company like BAC , which corresponded with a 5% year over year decline in revenues for the same period may be as good as it gets for 2014.

When investors return from the July 4th holiday in a little more than a week, they will be squarely focused on US banks as they will be the first sector to report q2 results in earnest with C July 14th, GS & JPM July 15th, and BAC July 16th.

A couple weeks ago Enis laid out a fairly simple bear case for BAC (below), but in a week that saw the yield on the ten year Treasury once again flirt with 2.5%, investors don’t seem to have a clue what to do with banks stocks, as BAC, C, GS, and JPM are all down on the year.  What also sticks out to me is the very poor performance this week of European banks, with the EuroStoxx Bank Index (SX7E) down 4.25% with the opening tick Monday morning serving as the high, and closing a fraction off of the lows.  If you were looking at the shares of Deutsche Bank (DB), BNP (BNQY) and Barclay’s (BCS)  this week (DB down 4%, BNQY down 3% and BCS down 7.7%) one would think that another financial crisis is looming.  Obviously, there are some fairly company specific things going on from DB needing to raise more capital, and the US feds going after BCS and BNP for alleged improprieties, but taken as a whole the price action is bad.

From where we are sitting, BAC is the one in the U.S. that sported the worst Q1 results of its U.S. cohorts and is likely to remain under regulatory scrutiny after the embarrassing stress test rejection from earlier in the spring.  Yet despite the stock being down on the year, implied volatility or the price of options in the stock remain fairly cheap heading into its Q2 print on July 16th.  The one year chart of 30 day at the money implied vol below, shows despite a healthy bounce off of the Fall lows, likely remains well below levels they have reached prior to the last few earnings reports:

BAC 1yr chart of 30 day at the money IV from Bloomberg
BAC 1yr chart of 30 day at the money IV from Bloomberg

While this may make sense given the low levels of overall vol in the market, with the impending event and the sector’s under-performance and potential for a second half reset of guidance, puts look cheap.

From a technical standpoint, the stock is broken, the 2 year chart below shows the amazing uptrend off of the 2012 lows that resulted in more than 100% gains from the stock’s trough, but since breaking $16 to the downside, and the uptrend back in April, that level should serve as staunch resistance.  In the next broad market swoon, or on the heels of stock specific news I would expect BAC to re-test$14:

BAC 2 year chart from Bloomberg
BAC 2 year chart from Bloomberg

Given that we are heading into a holiday shortened week next week, short term long premium strategies could be challenged and you will want to look to finance directional bets.  I am of the mindset that BAC will disappoint in Q2 and offer squishy forward guidance, but to make this bet I want to offset some decay in the meantime.

TRADE: BAC ($15.36) Buy July 11th weekly /Aug 15 Put Spread for .24

-Sell to Open July 11th weekly 15 put at .08

-Buy to Open Aug regular 15 put for .32

Break-Even on July 11th weekly Expiration:

-Profits are maximized at 15 on July 11th weekly expiration. Slight moves above and below that strike are also profitable with big moves higher or lower putting the structure at risk of losses on expiration.

-Max risk is 24 cents

Rationale:  I want to own what I think are dollar and vol cheap puts for the July 16th event and beyond, but I want to look to help finance the purchase of the puts as I do not see any meaningful catalysts (aside from potential market move) to move the stock up or down significantly in the time prior.  I am choosing the Aug regular puts because I would like to give the trade some time to play out even if BAC is up initially on the report.





Previous Post June 11th, 2014:  Name That Trade – Back to $BAC

BAC has been on our radar ever since a lackluster Q1 earnings report.  We had a profitable bearish trade in the spring, which we closed for a triple.  In the rationale for that trade, we outlined the weak results and high expectations at BAC:

Of the large bank stocks, C and MS had the best all around reports, while JPM and BAC were on the weak end of the spectrum.  While the market punished JPM for its missteps (stock is trading near 5 month lows), BAC held up much better despite a weak overall report, particularly the slowing reserve release and the potential for further legal losses going forward.

Meanwhile, analyst expectations for BAC in 2015 and 2016 are much higher than for any of the other bank stocks.  Analysts have modeled in $1.59 in EPS in 2015 and $1.81 in EPS in 2016 for BAC, vs. only $1.04 in 2014.  Most of BAC’s peers only have earnings growth expectations of 5-10% over the next couple years.  A big reason for the jump is BAC’s continued restructuring program, but that’s an awfully large jump for a company that did not sound too optimistic on the earnings call last week.

This morning, the Department of Justice has indicated that it will not accept BAC’s $12 billion settlement offer, and insists on its initial fine of $17 billion.  For context, $17 billion is close to the stock’s total earnings from 2012 and 2013 combined.  Obviously, the market has discounted this settlement over the past 6 months, but I point it out because the government’s newfound aggressiveness in fining the banks (see its fine of BNP last week) is an ongoing regulatory risk for the too-big-to-fail financial stocks.

Despite a slew of negative headlines over the past couple months (including a suspension of the company’s buyback and dividend increase after the Fed found discrepancies in the company’s capital calculations), BAC stock has rallied back to the crucial $16 pivot level:

BAC daily chart, 50 day ma in pink, 200 day ma in yellow, Courtesy of Bloomberg
BAC daily chart, 50 day ma in pink, 200 day ma in yellow, Courtesy of Bloomberg

The $16 level acted as support for much of the January – April period, before the stock gapped lower in late April.  The retracement looks like a good technical opportunity to play for a move back to the $14-$15 area, especially if BAC breaks the moving average confluence around $15.50, which is also the unchanged mark for the year.

The stock was down more than 1% this morning after the negative settlement news, though it has rallied back this morning to -0.75%.  We don’t want to enter a new position on such a down day.  Rather, we’re on the lookout for a move back to near $16, where we’re likely to enter a simple long Jul19th or Aug 16 put position, which would capture earnings in mid-July.

What’s our view on second quarter earnings for BAC?  First of all, JPM already guided the second quarter lower back in early May, with negative comments about the trends in most of the businesses.  GS research summarized the negative backdrop in May with this summary:

We point to (1) weaker equity (follow on) and debt capital markets issuance, which is likely weighing on secondary trading activity, (2) extremely low levels of rate volatility, (3) depressed mortgage trading activity, and (4) a return to more normal activity and volatility in commodities markets.

Analysts have modeled in a 4% earnings contraction year-over-year in BAC.  That is actually better than JPM, C, and GS, for which analysts have modeled in a 8-13% yoy contraction.  MS is the one standout after a weak second quarter number last year and strength in wealth management.

With that in mind, both the fundamental and technical backdrop look favorable to us.  For now, we’ll wait for the right entry for a new trade.