Bank Of America And The Fiscal Cliff

| About: Bank of (BAC)

The potential fiscal cliff will adversely impact U.S. equity valuations. Bank of America (NYSE:BAC) and the fiscal cliff is the focus of this article.

I'm writing about BAC because I follow bank stocks. Bank of America isn't the stock that will be most impacted by the fiscal cliff. I don't try to find stocks that will be most impacted by an event: 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 Bank of America. The share price of Bank of America is trending higher.

The firm is a laggard during this corrective wave and the share price is expected 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 in their models. Thus, I'm not disclosing the inputs in 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.

Federal Deficit

Receipts Outlays Deficit
2011 2302.5 3599.3 -1296.8
2012 2449.1 3538.4 -1089.3
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
Click to enlarge

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.

Further, Republican leadership expressed a desire not to increase tax rates without tax-code reform. The leaders of the Democrat party believe taxes on the wealthy should increase. I don't think tax-code reform is going to happen in a month.

Thus, the most likely outcome, in my opinion, of the federal budget debate is to maintain current fiscal outlay levels. My preferred outcome is a slight reduction in fiscal 2013 outlays compared to fiscal 2012. The decline may come in current-dollar terms or real-dollar terms.

In October, the first month of fiscal 2013, the budget deficit was about $120 billion. The year-to-date deficit was larger than 2012's as outlays increased faster than receipts. The fiscal deficit for 2013 is projected to be about $990.6 billion, according to the Office of Management and Budget. As previously stated, without changes to current legislation I project a budget deficit of $960.9 billion.

Current-dollar GDP was roughly $15.78 trillion in 2012's third quarter. The revenue increases and spending cuts from the fiscal cliff are about 4 percent of GDP.

Apply a multiplier of 1.3 the fiscal cliff would be about 5.2 percent of GDP. Please note, the multiplier of 1.3 is an estimate. In other words, the cliff is quite steep.

Under the scenario without the fiscal cliff shares of Bank of America return 50 percent next year. The fiscal cliff scenario suggests a return of about negative 40 percent next year. Finally, the scenario with a $200 billion reduction in federal expenditure suggests shares of Bank of America should return 30-40 percent in 2013.

I will have to see how the year closes, and how the stock trades next year before I can give more accurate 2013 year-end targets.

All of the return assumptions and deficit projections are subject to revision as new information is added to financial models.

Financial Analysis

Total revenue net of interest expense is trending lower and net income is also trending lower, however, net income is rebounding from the 2010 low. Net income is on pace to increase this year compared to 2011.

Bank of America's revenue from almost every operating segment is trending lower. The segments with revenue trending higher are global banking and global wealth and investment management.

Global markets was one of the largest operating segments by revenue and is now one of the smallest. Revenue from consumer and business banking fell off of a cliff.

Based on the revenue from the operating segments, Bank of America hasn't turned the corner following the financial crisis.

Bank of America has the lowest return on equity when compared to Citigroup and JPMorgan Chase & Co.

Moynihan is planning to cut $8 billion in annual expenses and more than 30,000 jobs which should boost return on equity and net income.

Macroeconomic Influences

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.

Solvency

The tier one capital ratio, a measure of solvency, increased the past several quarters. At the end of 2010, the tier one capital ratio was 11.24. At the end of the third quarter of 2012, the tier one capital ratio rose to 13.64.

Compared to its peers JPMorgan Chase & Co. and Citigroup, Bank of America had the lowest Basel 1 tier one common capital ratio.

However, Bank of America had the lowest financial leverage ratio. Financial leverage measures a company's ability to meet its debt obligations.

Valuations

Based on a present value dividend discount model, Bank of America is worth about $10.29-share. The market price of $9.12-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 Bank of America is fairly valued to overvalued.

Investment Thesis

Overall, Bank of America is performing well financially and has a solid financial position. That said, the 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 good 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 Bank of America declines.

A resolution of the fiscal cliff could stem the decline and shares of Bank of America could form a technical bottom.

Traders should be short shares of Bank of America. Investors should reduce long-equity exposure. Long-term investors should accumulate at lower levels, possible near $8.00, however, market conditions would dictate the actual entry level.

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. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.