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Contrarian, macro, hedge fund manager, Emerging Markets
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Financials have been one of the most battered and volatile sectors in the market. This recent rally in the past two weeks, however, has given traders an opportunity to re-enter short positions on overbought and fundamentally weak banks. However, to protect yourself from severe upside volatility, I recommend entering a less weak stock affiliated with the industry to hedge your bets and profit off relative performance. That is why I am shorting Bank of America (NYSE:BAC) and long on Value Line Inc. (VALU).

The reasons to short Bank of America are well known and have remained unchanged since my last commentary on the stock. Bank of America is fundamentally insolvent due to bad mortgages on its balance sheet and off-balance sheet commitments to repay buyers of securitized mortgages sold off by Countrywide. These problems are not tied to Europe in any material way, so a resolution in the European debt crisis does not help Bank of America's long-term solvency. It also faces other risks such as lost revenue from selling strong assets to cover losses and severe litigation liabilities. Depositors (or former depositors) have grown skeptical of its long-term viability and the likelihood of raising fees, which has (and will continue to cause) capital drain. Technically, Bank of America is overbought. It faces a strong resistance at $5.90, resistance at its 50-day moving average, and a gap up created by Tuesday's euphoria.

I'm overall still strongly bearish of financials, but Value Line is the least ugly pig in the pen and is set up well for a good short-term trade. It is not a bank, but does correlate with the financials because buy side firms and investment banks slash Value Line subscriptions when times are bad and vice versa. The reason I'm buying this to hedge my Bank of America short is because of its cheap valuation, strongly oversold technicals, and strong 7.8% dividend yield. Value Line has no debt, a return on investment capital of over 123%, and a P/E ratio of just 2.66. Value Line is also within 2% of its 52-week low. Technically, the stock is also signaling that it is strongly oversold with a RSI under 30, and a full stochastics measure of just 14. The stock is due for a rally due to its cheap valuation and the close proximity to its ex-dividend date. Based on previous payout schedules, the next ex-date is expected to be in late January. Another thing to factor in is that due to the 2008 crash and the severe amount of redemptions that occurred last autumn, the number of money managers in the industry may be in the process of bottoming out.

Overall, I think this an excellent short term (6 weeks or less) to capitalize off the volatility of financials. I think Bank of America will retest the $4.96 lows (and may break through) and Value Line will maintain its value (plus the ~2% quarterly dividend) with room for small upside during this time frame.

Source: Short-Term Financial Pair Trade: Long Value Line And Short Bank Of America