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Summary

  • The stock has fallen straight down 13% in short order with no sign of stopping.
  • The drop is mainly related to the wholesale sell off of the financial sector.
  • This has produced a major buying opportunity in the stock.
  • Fundamentals and valuation are solid.

Those of you who follow me know I am very bullish on Bank of America (NYSE:BAC). The stock passed the stress test with no issues and is still fundamentally undervalued on a relative and historical basis. Nevertheless, the stock has not been immune to the current major macro selloff. Even so, the question remains - is this really the only reason? There are some issues to consider. In the following sections I will do my best to distill the current situation and provide some guidance on when I would start a position in the stock.

The stock has fallen straight down 13% in short order with no sign of stopping

Bank of America continues to sell off relentlessly since the results of the stress tests were published. The market is currently selling off in a wholesale manner. When this occurs, fundamentally sound stocks are sold off indiscriminately with the rest of the market.

(Chart provided by CNBC.com)

This has created a buying opportunity in Bank of America no doubt. The problem is - when will the selling relent? The stock is at present the definition of a falling knife, which is inherently hard to catch without getting hurt.

The drop is mainly related to the wholesale sell off of the financial sector

The market has entered a period of extreme volatility. The last few days have been brutal, whipsawing stocks without reason. Moreover, we have ended the week on a major down note. The correlation between the drop in Bank of America's stock and the wholesale sell off of the financial sector is evidenced by the symmetry of Bank of America's stock and the Financial Select Sector SPDR Fund's (NYSEARCA:XLF) performance. See chart below.

(Chart provided by CNBC.com)

As you can see, Bank of America's stock substantially mimics the moves in the XLF. Bank of America's stock has taken a deeper dive due to the stock's beta of 1.73. This means the stock is subject to much higher (or lower) moves as compared to the market as a whole by almost a 2 to 1 ratio. This accounts for the 10% decline in Bank of America's stock versus the XLF's 4% drop. I posit the selloff is more related to profit taking and tax loss selling rather than anything else. With the market up approximately 30% last year, many savvy investors are taking profits prior to April 15th in order to pay for taxes on gains.

This has produced a major buying opportunity in the stock

The unwarranted selloff of Bank of America's stock has my contrarian juices flowing. A contrarian is one who attempts to profit by investing in a manner that differs from the crowd, when the crowd's opinion appears to be wrong. A contrarian believes that the herd mentality exhibited by many investors can lead to exploitable mispricings in stocks.

For example, widespread pessimism about a stock can drive a price so low that it overstates the company's risks, and understates its prospects for returning to profitability. Identifying and purchasing such distressed stocks, and selling them after the company recovers, can lead to above-average gains. I believe this is the case with Bank of America currently.

Fundamentals and valuation are solid and improving

The stock is trading for a price to tangible book value of 1.2 versus the industry and peer average of 1.6. Furthermore, Bank of America is trading for a PEG ratio of .72, which is the lowest of all five major banks.

(Table provided by Yahoo.com)

The PEG ratio is a broadly-used indicator of a stock's prospective worth. It is preferred by numerous analysts over the price/earnings ratio because it also accounts for growth. Similar to the P/E ratio, a lower PEG means that the stock is undervalued. Many financiers use 1 as the cut-off point for PEG ratios. A PEG of 1 or less is believed to be favorable. As Warren Buffett would say, "Price is what you pay, value is what you get." I submit Bank of America is the best buy out of all the banks.

Wait for this to happen prior to starting a position

It is hard to call a bottom in a stock. The old saying, never catch a falling knife, is very true. So prior to starting a position in the stock, I would wait for a trend reversal.

(click to enlarge)

(Chart provided by Finviz.com)

The stock broke below major support at the 50-Day SMA. The next significant support level is at the 200-Day SMA, or $15.00 mark. I believe that's may be where the bulls make a stand. I would definitely wait for the stock to reverse trend prior to starting a position. The 200 day SMA looks like the line in the sand. If it is defended, this will be the time to buy.

Downside Risks

The decline in long-term interest rates has caused the yield curve to flatten substantially. This will pressure the bank's profit margins inexorably. Moreover, a flattening yield curve is indicative of a looming recession - so they say. The bank reports earnings early next week. Based on current market conditions, if the bank doesn't exceed earnings by a wide margin, the stock may take another drastic slide downwards.

The greater concern may be the fact the yield curve actually flattened during the current quarter, not the last. Consequently, forward guidance may be somewhat tempered. This does not bode well for the stock in the near term.

Conclusion

Great periods of strength in stocks and markets in general are typically following by major corrections. It remains to be seen if the recent downturn in the market morphs into a full-fledged 20% correction. The current put/call ratio in the XLF is 5 to 1. This is a sign market participants are expecting more downside to come for the banks.

With both Bank of America's stock and the XLF definitively breaking trend, I am on the sidelines until the selling abates. Once the trend reverses, the risk/reward equation to go long the stock will be much more favorable. Most importantly, I want to stress the fact you should layer into any position. In fact, under current market conditions, I would scale in to the position using 10% increments over the next few weeks, or months even. This will significantly reduce risk as more volatility surely lies ahead.

Source: Bank Of America: Catching A Falling Knife Can Be Painful