The potential fiscal cliff will adversely impact U.S. equity valuations. JPMorgan Chase & Co. (JPM) and the fiscal cliff is the focus of this article.
I'm writing about JPM because I follow banks stocks. No, JPM isn't the stock that will be most impacted by the fiscal cliff. I don't care which stock will be most impacted by the fiscal cliff: my investment policy statement isn't based on event driven investing.
Before I discuss the fiscal cliff it is important to discuss the current state of the market for common equity shares of JPMorgan Chase & Co. The share price of JPMorgan Chase & Co. just started trending lower.
The firm is a laggard during this corrective wave and the share price is expected to continue to decline. A catalyst for the decline is the fiscal cliff.
Market participants are expressing some concern over potential U.S. federal government expenditure cuts and revenue increases of more than $600 billion set to take effect in 2013.
In providing forecasts, analysts use either historic data, guessing, or some combination of both. In making projections I combine historic data and guessing.
Rarely do analyst disclose the inputs into their models. Thus, I'm not disclosing the inputs into my models.
Without the fiscal cliff, I project a deficit of about $960 billion. Outlays are forecasted to be little changed from the 2012 level, and receipts are forecasted to increase to about $2.59 trillion.
With the fiscal cliff, I project a budget deficit of about $850 billion. Outlays decline but receipts also decline as the impact of the decreased government expenditure decreases federal revenue.
Under a third assumption, about $200 billion of fiscal cliff takes effect in 2013. Most of the cuts come from reductions in outlays and the budget deficit is roughly $838 billion.
|2013 Projected (No Fiscal Cliff)||2589.1||3550||-960.9|
|2013 Projected (Fiscal Cliff)||2200||3050||-850|
|2013 Projected (Mild Fiscal Cliff)||2500||3338.4||-838.4|
Without the fiscal cliff, U.S. economic growth is roughly 2 percent. With the fiscal cliff U.S. growth is negative in 2013. With a mild fiscal cliff, U.S. growth is slightly slower than under the no fiscal cliff scenario.
Under the scenario without the fiscal cliff, shares of JPMorgan Chase & Co. return 25 percent next year.
The fiscal cliff scenario suggests a return of about negative 25 percent next year. Finally, the scenario with a $200 billion reduction in federal expenditure suggests shares of JPMorgan Chase & Co. should return 15 - 20 percent in 2013.
All of the return assumptions and deficit projections are subject to revision as new information is added to financial models.
From a financial analysis perspective, JPMorgan's net income is trending higher. Total equity is also trending higher. The cash balance is increasing, and the Basel I tier 1 common ratio was 10.4 percent on September 30, 2012.
In terms of the operating segments, investment banking revenue remains range bound between $4.5 billion and $8 billion.
The retail financial services revenue is trending higher and is near a recent peak of just under $9 billion.
Card service and auto revenue is trending higher but has been between roughly $4.5 billion and $5 billion the past few quarters.
Also, revenue from the asset management segment is trending higher. The macro-economic data has been positive for valuations.
The advance reading of third quarter GDP said the economy expanded at an annualized rate of 2.0 percent that is up from 1.3 percent in the second quarter. A faster pace of expansion leads to increased demand for financial services.
Interest rates have remained at extraordinarily low levels as the Federal Reserve maintains its quantitative easing program. Recent data points suggest increased demand for auto and home loans. Further, businesses have increased borrowing as lending standards eased.
The PCE price index, excluding food and energy, increased 0.1 percent in September, the same increase as in August. The subdued level of inflation suggests interest rates should remain low, and consumers and businesses should remain relatively confident. Right now, I'm not concerned about the solvency of the enterprise.
The tier one capital ratio, a measure of solvency, increased the past several years. At the end of 2004, the tier one capital ratio was 8.7 and declined to a low of 8.4 at the end of 2007's fourth quarter before reaching a high of 12.3 at the end of 2011. At the end of 2012's third quarter, the tier one capital ratio was reported as 11.9. The increase in the firm's tier one capital ratio is expected to be sustained.
In comparison, Bank of America's Basel 1 tier one common capital ratio was 11.4 percent at the end of 2012's third quarter. Citigroup's Basel 1 tier one common capital ratio was 12.7 percent at the end of 2012's third quarter.
Compared to its peers, JPMorgan Chase & Co.'s Basel 1 tier one common capital ratio was lower than Citigroup's and higher than Bank of America's.
Although the amount of tier one capital increased, the financial leverage increased. In 2005, the financial leverage ratio was 11.09 and reached a high of 12.88 in 2008 before declining to about 12 in 2012. Based on the financial leverage ratio, JPMorgan became less able to meet its debt obligations.
JPMorgan Chase & Co.'s financial leverage ratio is higher than both Citigroup's and Bank of America's.
Based on a present value dividend discount model, JPMorgan is worth about $39.50-share. The current market price of about $41-share suggests the firm is fairly valued.
Using short-term multiplier model valuations, the firm is fairly valued to overvalued. Based on the absolute values of the multiplier model valuations, JPMorgan Chase & Co. is fairly valued.
Overall, JPMorgan Chase & Co. is performing well financially and has a solid financial position. That said, the short-term valuations are ahead of reality.
There has been plenty of good news that has been discounted by the market. At this point, it would take extraordinary news to move shares higher in price.
The uncertainty surrounding the fiscal cliff should act as a catalyst to drive share prices lower as the premium investors are willing to pay for shares of JPMorgan Chase & Co. declines.
A resolution of the fiscal cliff could stem the decline and shares of JPMorgan Chase & Co. could form a technical bottom.
Traders should be short shares of JPMorgan Chase & Co. Investors should reduce long-equity exposure.
Disclaimer: This article is not meant to establish or continue an investment advisory relationship. Before investing, readers should consult their financial advisor. Christopher Grosvenor does not know your financial situation and ability to bear risk and thus his opinions may not be suitable for all investors.
Disclosure: I am short SPY.