Is a major buying opportunity at hand?

Consider a sampling: Bank of America Corp. (BoA), recently priced at US$11.95, is down by 29% year- to-date, while JPMorgan Chase & Co. (US$54.49) and Wells Fargo & Co. (US$47.30) both are off by 13%. Thus, investors are feeling bank pain, as “money centre too big to fail” banks are pounded into submission by a sentiment-driven sell-off in the markets overall.

The sell-off cannot be blamed on any news that caught investors by surprise. It has more to do with how investors are interpreting facts already in play. Oil production is outstripping demand and stock prices in that sector are falling. That’s not new. Bankruptcies in the oilpatch could lead to a 2008-style liquidity crisis. That’s a different interpretation.

The reality is that oil production and exploration account for 1%-3% of loan portfolios for U.S. money-centre banks. Not all of these loans will default; stronger companies will buy smaller players at bargain-basement prices, as already evidenced by Suncor Energy Inc.’s $4.2- billion acquisition of Canadian Oil Sands Ltd. in January. Certainly, some loans will be written down. Painful, but not catastrophic.

The U.S. Federal Reserve Board raised interest rates by 15 to 25 basis points (bps) in mid-December. Predictions that the Fed would initiate four more hikes in 2016 began to surface. U.S. banks rallied on the perception that higher interest rates would improve net interest margins, which make up 50% of the banks’ profits.

Then, late in December and into January, another possible scenario emerged: could the Fed follow the lead of Japan and set in motion a campaign of negative interest rates? Again, a different interpretation, as Japan has had negative interest rates for the past four months. Negative interest rates would cause serious damage to the U.S. banking system, although I believe the damage would be far less than what has been imputed by the sell-off earlier this year.

The goal in a sentiment-driven environment is to separate emotions from reality. Make no mistake: sentiment is propelling this market. How else do you explain Japanese investors’ willingness to buy 10-year government bonds for which they are guaranteed to earn minus seven bps a year?

In my mind – and, apparently, in the mind of Jamie Dimon, chairman, president and CEO of JPMorgan Chase – sentiment eventually will give way to reality. A negative interest rate scenario in the U.S. and Canada is highly unlikely, given the enormity of our money markets; these markets would be decimated by such a move. Furthermore, North America is not experiencing a Japan-style deflationary environment caused by aging demographics, a situation resulting from questionable immigration policy.

I foresee a very different outcome. As Fed chairwoman Janet Yellen explained to Congress in her recent testimony, inflation is well entrenched (aside from in the energy sector). And when Congress asked Yellen to comment on the oil market, she contended that oil prices are falling and will stabilize eventually. Thus, I suspect that we will see another Fed interest rate hike in the second quarter of 2016 and perhaps another by the end of the year. The notion that we would see four rate interest hikes in 2016 was never plausible. Global economic growth is too anemic.

I suspect another interest rate hike will be an inflection point that will cause a shift in sentiment as investors accept the reality that negative interest rates are not likely. And, on the back of that, look for bank stocks to rally and lead other sectors higher – probably as part of the year’s second-half story. In the end, markets are likely to end the year slightly higher or, at worst, where they began 2016.

If that scenario unfolds, we have a major buying opportunity. That’s a view shared by Dimon, who invested US$26 million of his own money to increase his stake in the bank he oversees. As a result of that, you may want to encourage your clients to spend some of the hordes of cash currently on the sidelines. Put some of that cash to work in the banking sector with a “no pain, no gain” pitch.

Recognizing that clients can be slow on the uptake, you may want to nibble on financials using options – especially with above-average premiums that currently exist. To that end, writing three- to five-month, cash-secured in-the-money puts seems like an ideal strategy. Especially if you buy into the second-half storyline.

When we talk about cash-secured puts, we are talking about setting aside sufficient cash to buy the underlying shares should the puts be assigned. In the case of U.S. stocks, you might think about keeping the cash in Canadian dollars (C$), as the loonie should strengthen when oil prices stabilize. That scenario is likely to unfold over the next couple of months.

For specific examples, consider selling BoA May 14 puts at US$2.45. A cash-secured position would require clients to set aside the C$ equivalent of US$11.55 a share (US$14 strike price minus US$2.45 premium received).

If BoA stock is below the US$14 strike price at the May expiration, your clients should take possession of the shares and, depending on market conditions, sell close-to-the-money covered calls.

Similar positions could be established with Wells Fargo April 50 puts at US$3.70 or JPMorgan Chase May 60 puts at US $5.30.

You might look at more aggressive positions, such as buying calls on Canadian banks. For example, buy Royal Bank of Canada (recently priced at $68 a share) July 68 calls at $4.60. If the stock jumps and the calls double, sell half the position and ride the remainder.

National Bank of Canada ($36.80) is another example; but with a 5.87% dividend, I would look at buying the shares and selling near-to-the-money April 40 calls at 85¢.

© 2016 Investment Executive. All rights reserved.