“It is time to fade the rally” were my exact words from my last write up on Wells Fargo (NYSE:WFC) and Wells Fargo stock in early June. What followed was a 25% correction that unfolded in about two weeks.
Financial stocks are a conundrum to most experts, but that’s because they fail to grasp the prevailing concept. Wells Fargo stock and other banks have a ton of value but none of the spark. This is an artificial environment for them because of what the central banks are doing across the globe. That’s why they can’t seem to hold their greens too long.
You’ve heard of TINA (the acronym for “there is no alternative“), and that it hurts bank stocks because it puts a lid on yields. On the other hand, it also keeps investors interested in owning bank stocks because they are strong dividend payers. This dynamic keeps a lid on upside but places a bid which guarantees support on dips.
Banks recently passed the Fed stress test and WFC fared the worst. At face value this is a bad thing, but not really because now the bad news is out of the way and already priced into the stock.
Wells Fargo Stock Is Long on Value
It is a known fact that banks are cheap. JPMorgan (NYSE:JPM), which is the best of them, only commands a 13x price-to-earnings ratio and barely over book-value. From that perspective Well Fargo stock is outrageously expensive with a P/E more than twice that of JPM.
Luckily for WFC bulls, value matters very little for the potential upside of the stock. It’s historically not been a reason to rally and it won’t be a reason to short. In absolute terms, the downside in it is limited with current conditions. In fact, its stock price is .6 of its book value, so investors are only giving it credit for barely over half its assets.
Since value is not a price driver then, the best clues come from the charts. They have been very reliable to guide successful trading for over a year. Unlike most of the stocks, WFC did not bottom in March because it dipped another 13% into the May low. It has since established a higher bounce level near $23.4 per share. The assumption now is that this will be support that the bulls can use to remount another rally. Onus is on the bears to force them back to the May low.
Trade Smarter, Not Harder
The easy trade here is to buy the shares for the long term and set a stop loss that fits one’s risk appetite. But since we’ve already established the fact that they are slow upward movers, this will require patience.
Luckily the options markets offer alternatives where investors can manipulate time in ways to expedite results. Traditionally, traders like to buy call options, but in this case, they would be setting time to be an enemy not a friend. The better alternative is to sell puts into proven support and let time to do the heavy lifting. This would be a commitment to buy shares lower.
The 2020 low that WFC hit has been in contention since 1998. Only the financial crisis broke below it. Back then it was a balance sheet problem and banks viability was in question. This year’s crisis is a general profit and loss statement problem. It could extend to the banks but they have already committed loss loan reserves per the new rules and regulations.
Therefore, I am confident to own shares of Wells Fargo stock near $20 per share. The trade for this using the options is to sell the January WFC January $20 put and collect $1.15 per contract for it. Not only does it not need a rally to win, but it would have to fall more than 22% from here to start losing money. As long as WFC is above the put sold then this trade yields its maximum profits.
There Could Be Trouble from the Asset Values
It is also important to note that there is an added risk from the current forbearance programs. This is a trend set in motion by the CARES Act. Current estimates are that 8% of all U.S. mortgages are in forbearance and we don’t know how it will end. It is easy to imagine a complete debacle because U.S. consumers like to spend, so chances are they are not saving the money required for them to get out of the program.
This can continue for a few more months but eventually and as early as December we could have a real estate problem of sorts. This is not to raise the alarm a-la 2008 debacle because this time around the banks are financial fortresses.
The bottom line is that Wells Fargo stock is long on value but short on spark. Wall Street investors will fade the rallies so it is important to be smart with picking tactical entry points. After just losing a quarter of its value without a major change in outlook now is an appropriate starting spot.
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.
