Earlier in the week I had some thoughts on the performance of bank stocks both here and abroad, specifically the very poor performance over the last month in Deutsche Bank (DB) equity and credit (Big Printin’ – Achtung DB) and then on the relative under-performance of large cap moneycenter banks like JP Morgan (JPM) here in the U.S. off of the February 11th lows (MorningWord 4/7/16: Left Banks). From yesterday’s post on JPM I had the following to say:
What to do with U.S. bank stocks? As we have noted on a few occasions of late, they have under-performed the S&P 500 from the May 2015 highs, as well as year to date and most importantly off of the February low. JPM for instance put in a “Dimon Bottom” when he bought $26 million worth of stock between $53 and $54 at the 2016 lows on Feb 11th, and the company last month announced a $1.9 billion buyback. But despite that, the stock is only up 12% from Feb 11th vs the SPX up 14% and maybe more importantly, the SPX is now only 3% from its all time highs made last spring while JPM is 17% from its July 2015 52 week high. It appears that investors are fading Dimon’s commentary.
As we head into Q1 earnings season, where bank stocks are first to report en masse, with BAC, C, JPM and WFC set to report next week, expectations are not exactly high as C and JPM management’s have already talked down Q1 results (which were highlighted by disgusting results from JPM in the Dec to February period). While I would be a tad hesitant to press bank stocks into earnings given low expectations, poor sentiment and even poorer price action, they are likely to be a great trading short on rallies.
So here is the deal. It’s my view that the Fed has made a mess of their communication about their interest rate policy intentions. After nearly a decade the Fed raised interest rates in December off of the 0% bound, and given their commentary at the time, investors began to price 3 to 4 more rate hikes in 2016. Well, in January and February fears of a global slowdown and divergent monetary policies among the world’s major economies and the Fed’s rhetoric and hawkish tone was turned on its head, despite what appears to be improving economic data. It’s my view that the Fed does not want to raise given the fragile nature off our economy and the general weakness in emerging markets and Europe. This uncertainty has weighed on bank stocks as our banks need a steeper yield curve to make money!!
via a wealth effect and its trickle-down effect on the real economy, negative investment rates and the expansion of central bank balance sheets via quantitative easing are creating negative effects
And this is where he turns his sights on bank stocks:
Negative yields threaten bank profit margins as yield curves flatten worldwide and bank NIM’s (net interest rate margins) narrow. The recent collapse in worldwide bank stock prices can be explained not so much by potential defaults in the energy/commodity complex, as by investor recognition that banks are now not only being more tightly regulated, but that future ROE’s will be much akin to a utility stock.
Do not reach for the tantalizing apple of high yield or the low price/ book ratio of bank stocks. Those prices are where they are because of low/negative interest rates.
My view has not changed, and the price action in Euro banks in some way emboldens this view. BUT, there is risk to a short entry here for one main reason. When the Fed meets on April 27th, they will not raise rates, but Fed Funds futures are pricing only a 17% chance of a raise at the following meeting on June 15th. If this was to be ratcheted up by the Fed’s commentary in a few weeks, then we could see a short squeeze in U.S. banks which have under-performed dramatically ytd, down 7% with healthcare the only other sector down on the year.
So timing is a massive issue of short bets against U.S. banks. If the Fed remains Dovish, and stocks rally, banks will likely to continue to under-perform, if they get hawkish there is a chance the group rallies, but if we get the sort of response we saw in Jan/Feb to rate increases then the stocks could suffer as they did in Q1.
I want to finance purchase of longer dated put purchases, assuming that nothing good happens between now and the end of the summer, and that this is a sector that should be sold on rallies.
So what’s the Trade?
*XLF ($22.10) Buy Sept 22 / May 21 diagonal calendar put spread for 90 cents
- Buy Sept 22 put for 1.15 (49 deltas – 49% chance in the money)
- Sell May 21 put at .25 (24 deltas- 24% chance in the money)
Break-Even on May Expiration:
The ideal situation is that the XLF is at $21 or slightly above. I am not playing for a breakdown over the next month given the weakness of late in the sector. But if the stock is 21 or higher then the May 21 puts will expire worthless and if the etf is below 22 then the Sept 22 puts should increase in value and the premium received for shorting the May out of the money put should offset some decay.
At some point prior to May expiration I would likely roll the short strike into another diagonal calendar, or turn into a vertical.
Rationale: First on the strikes. I want to be low a very near the money put, and the 22 strike appears to be an important support level (red line). On the short side, i want to have a near dated out of the money put to help finance the longer dated one, $21, seems like reasonable near term support:
Because the width of the calendar spread is only 1.00 and it costs .90 there of course is the risk that it declines too fast (between now and May) but unlike a same strike calendar it can’t lose money if that happens. And there are worse things that could happen to this trade than it going down too fast. Because it is differing strikes a move to the upside obviously is the most risk as it leans more short deltas than a same strike spread. So consider this a slightly more aggressive bearish calendar than a same strike calendar to the downside.