Seeking Alpha
Long/short equity, contrarian, hedge fund manager, macro
Profile| Send Message|
( followers)  

All macro indications point to the beginning phases of removing Quantitative Easing (QE) from capital markets, albeit at a gradual pace so as not to upset a fragile economic recovery with parts of the world still clouded in uncertainty. In the early stages of this Fed action, we'll see improved margins at the banks while any increase in lending rates will result in negative pressure on margins at companies who rely on short-term paper for day to day operations (e.g. Biotech and Technology). In other words, avoid high beta stocks. This article will help the investor navigate this macro economic change that is underway. The reader should have a clear understanding of the global macro picture when done reading this article, the appropriate trading strategies to consider, specific stocks to trade within the sectors discussed, and in the event weakness in Europe spreads, any talk of removing QE from the economy will be abandoned leaving us with a fall back plan.

Monday's market action involved an aggressive rotation into many leading financial stocks. Bank of NY (NYSE:BK) became the nations #1 custodian of assets around the time Investment Capitalist suggested to SA readers that a long position in BK was worth considering on Feb 5, 2012 around $21/share. Moreover, the yield at the time was almost 3.5%, which has provided a boost in the overall ROI for our BK position to over 57%.

We're seeing rotation into financials while high beta sectors, notably technology and biotech, are under pressure. This is likely an early indication Wall Street is beginning to discount the removal of QE in 2014. It's also possible we'll see the first rate hike in 2015. Otherwise, the Fed is not likely to move until 2017 as 2016 is an election year. The Fed historically stays on the sidelines during election years.

As for high beta, bio-pharma has produced outstanding gains. For example, JAZZ Pharma (NASDAQ:JAZZ) is up over 600% during the same period we've been long BK. At $125, the stock is pricing in a likely takeover with Astra Zeneca (NYSE:AZN) often named as a likely suitor. Talks of a buyout increased last month when JAZZ spent $875mm to acquire Gentium. Rather than selling the position and swallowing a huge tax hit, it's more prudent to employ alternative strategies discussed below.

It pains me to let go of a top performer, but never has the saying "Pigs Get Slaughtered" been more apropos than now. To avoid a tax hit however, at a time when acquisition rumors are flying, is just cause to employ an alternative strategy. Rather than dumping the position and getting hit with capital gains, consider establishing a "bracket" around the stock using options. For example, one may buy out of the money puts while simultaneously selling in the money calls. The premium earned from the calls will more than cover the puts, leaving some income to the portfolio. A short-term correction, which wouldn't be a bad thing, would benefit the bracket on both sides while deferring capital gains tax. I wouldn't leave the bracket on too long. Perhaps a test of $100 would suffice, at which point, I'd close the bracket and go net long once again.

As for financials, Bank of New York made a solid push on Monday to $35 but $36.50 is the upper band of this 2 year rally. All indications point higher, and when the cost of borrowing goes up, banks are quick to pass those costs onto their customers. On the other hand, they're much less anxious to increase savings rates for depositors. As such, these opportunities are always exploited by banks to maximize earnings during a profitable macro environment that could last several years.

Goldman Sachs (NYSE:GS) and Citigroup (NYSE:C) are both breaking out of their 9 month ranges for the same reason, and Blackrock (NYSE:BLK) has always been a reliable long-term investment. Considering their aggressive push into ETFs, investors in Blackrock are likely to be rewarded in the next year or two even more than they have been in the last two years. I'll expand further using statistically based technical analysis of these sectors as I trade them aggressively, but am resigned to doing so on Investment Capitaist.

Ultimately, the bottom line is that there's a macro theme forming involving the ramifications of the Fed removing Quantitative Easing from the economy, and those ramifications are likely to be weakness in higher beta stocks and strength in financial stocks. We'll avoid talking about commodity stocks for now because that's an entirely different animal.

Company Description

Nation's largest custodian of funds, retail banking, commercial lending, merchant banking, Federal Reserve operations and private equity.

Thesis & Catalyst For The Bank of New York Mellon Corporation (BK)

The catalyst will be the implementation of a policy by the Fed to gradually reduce Quantitative Easing. This will result in an opportunity for banks to exploit a positive spread by rapidly increasing borrowing costs while simultaneously drawing out as long as possible any increase in interest rates paid to depositors.

A reduction or removal of QE will pressure high beta stocks such as Bio-Pharma and Technology, which tend to rely more on short-term borrowing to finance day-to-day operations.

Valuation

The position since first recommended on SA is up 45%. From the current range of $35, the next upside target is a nice round number of $50 because earnings growth and a low PE, combined with a consistent dividend will continue boosting income. Ultimately, the nations largest asset custodian is certainly a company worth owning for the long haul.

Variant View

The biggest risk comes from overseas. If Europe goes into another tailspin, then any talk of removing QE from the markets will vanish and the macro theme will reverse. Should this happen, financials are likely to go sideways while high beta stocks are likely to see strong rallies. So this is not really a "risk" but more of a tactical response to a change in our thesis. Either way, we make money.

Source: Changing Macro Themes - The Effects Of Removing QE; A Long Case For The Bank Of New York Mellon And The Banking Sector While Avoiding High Beta Stocks