Financial stocks rarely make for exciting trades. They do go through spurts of frantic price movement, but those typically don’t last long. Currently bank stocks are about 20% above the March lows but that is about half as much as the S&P 500. They are living up to the reputation that they cannot sustain rallies for long. That doesn’t mean that investors cannot profit from them, because the same things that make them somewhat boring, can generate profits.
Financial companies recently underwent their mandated stress tests, so that risk event is out of the way. But even though the results were good, authorities imposed limits on their financial engineering activities. They cannot do buybacks and their dividends are now bound to their financial performance. Investors reacted negatively to the headlines, not because of the scorecard itself, but rather from the fact that they will have to undergo more tests later this year.
Wall Street hates uncertainty, and this adds another risk event to the schedule in just a few months. Luckily for the bulls, headline risk is much different than imminent risk. The banks have fortress balance sheets in spite of the economic conditions and they will be just fine. They are all cheap and worth trading into what others fear.
Today we consider three financial stocks that could yield relatively easy profits well into 2021, and they are:
I consider this to be the second part of the original trade out of the quarantine correction. Back in April, I shared the first part which was to buy the upside potential, which delivered a more-than-25% rally. Now it’s time to add to these positions for growth that doesn’t necessitate more upside.
Fool Proof Financial Stocks to Trade into 2021: JPMorgan (JPM)
Consensus among investors is that JPMorgan, under the leadership of Jamie Dimon, is the best run bank. Whether that’s true or not doesn’t matter because perception is reality. Management has performed well on plans so investors have no reason to doubt them. And they rarely commit mistakes so there are no self-inflicted wounds.
Supremacy of a stock usually comes with a premium but not here. JPM stock is cheap in both absolute and relative terms. Like most other major banks, it carries a modest price-to-earnings ratio of 10.5 and a 1.2 price-to-book multiple. This is hardly a bloated equity, so owning shares for the long-term is not going to be a financial disaster.
But that’s about as exciting as it gets, which is not particularly. In this case, as with most other financial stocks, I prefer generating income by selling risk below current support, against their intrinsic values. This way even if the stock price disappoints, the worst case scenario is a totally acceptable financial event. The trade for JPMorgan stock this year is to sell the January $65 put and collect $2.3 per contract. This has an 85% theoretical chance of success and does not need a rally to win.
In fact, the stock can fall another 30% from here without causing any losses to investors. The upside is limited, but the relative safety of the strategy fits with how banks have been acting. If buying JPM stock is reasonable at current prices, then buying it 30% lower would be a steal and well worth the risk. It is important to note that JPM is fighting a bearish short-term chart pattern for as long as it remains below $94 per share.
Wells Fargo (WFC)
On the other end of the spectrum of financial stocks is Wells Fargo. This is the black sheep of the bunch, having created their own drama on Wall Street many time before. Most recently they were caught cheating while executing aggressive growth strategies and they have yet again come under regulatory fire from it.
Authorities have restricted management actions before, and the recent general bank restrictions just add to the headwinds for WFC stock. Some of the risk is already out because management cut the dividend in response to the stress test. This is nothing new, as WFC slashed their dividend by 85% in 2009, yet still managed to rally 130% from there.
With uncertainty comes relative explosiveness in the stock price. Investors who like momentum stocks probably prefer Wells Fargo over its competition. Since financial stocks already have many hurdles to overcome, I also prefer selling risk below WFC stock than buying the upside potential. While JPM and XLf are 200% and 150% above their respective 2011 lows, Wells Fargo is still stuck at those near-decade-old levels. These are uninspiring metrics for investors but therein lies some good news.
Often when a stock is lagging its sector, it has some catching up to do. By definition it also means that it has more relative upside potential as it heals from whatever ails it. From a valuation perspective, WFC stock is even cheaper than JPM, with a P/E ratio of 9 and selling at just 0.6 times its book value. Investors are barely willing to give it credit for a little more than half its assets. Such a low valuation should indicate a stock in danger of financial ruin, but that’s not the case for Wells Fargo.
This ultra-low valuation makes today’s strategy even safer because there’s the opposite of froth in WFC stock, now down to the bare bones. Investors can sell the January $20 put and collect $1.5 per contract. For this trade to lose money, the stock would have to fall more than 22% from Thursday’s close.
This also means the stock would have to set lower lows than the Covid-19 crash which is highly unlikely. I’m confident that owning Wells Fargo stock at the break-even price of $18.5 per share will be a great start for long-term holding. This is an ideal risk that leaves plenty of room for error during extremely uncertain times.
Financial Select Sector SPDR Fund (XLF)
Today’s third idea is to bet on all financials stocks with one blanket trade via the XLF ETF. The trend in this chart has been positive for over a decade. The recent correction should have shaken weak hands out of the stock and transferred ownership into owners with more conviction. The Covid-19 low was a great entry opportunity for those who took it. This was the same support level investors rode back in 2016 for a 60% rally before the correction this year.
Price action like this creates strong charts for the future. But the threats looming in our coronavirus economy are huge, so I still favor creating income without needing a rally. Thus, upside is limited and the room for a safety barrier is very attractive here. The bullish strategy for financial stocks continues to be in their value. The easiest way to monetize this is by using the options markets so investors can leave room for error.
The trade here is to sell the XLF $19 put and collect $1 for it. This may seem boring, but when risk is high, boring is beautiful. There are hundreds of other ways to use options to implement similar strategies. This one is a simple straightforward method to get paid now.
The worst case scenario is to buy great stocks at even greater prices down the road. Selling puts naked is hazardous, but only to investors unwilling or unable to own the shares. Otherwise it makes total financial sense for those who want to own cheap stocks at even better bargains.
It is important to note that my thesis for the banks into the end of the year isn’t fully positive. There’s a good chance that some of them will have problems stemming from the forbearance programs that are part of the CARES Act. It is likely that homeowners haven’t saved the government stimuli and that they will face problems as forbearance programs end. Of the three trades today, Wells Fargo probably has the biggest direct risk from that, but the sector trades in unison, so the rest will also suffer in sympathy.
Nicolas Chahine is the managing director of SellSpreads.com. As of this writing, he did not hold a position in any of the aforementioned securities.