Crystal Ball Says Add Sallie Mae Long And Wells Fargo Short

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Includes: SLM, WFC
by: Dark Horse Traders' Hedge

I used to like to walk the straight and narrow line

I used to think that everything was fine

Sometimes I'd like to sit and gaze for days through sleepless dreams

All alone and trapped in time

All alone and trapped in time

I wonder what tomorrow has in mind for me

Or am I even in its mind at all

Perhaps I'll get a chance to look ahead and see

Soon as I find myself a crystal ball

-Styx

Recently, I wrote about Patience, a quality often absent from the minds of investors especially following short-term swings. Today, I am writing about an element investors would love to have but don't, "perhaps I'll get a chance to look ahead and see, soon as I find myself a crystal ball." We often "wonder what tomorrow has in mind for me" and with regards to the Fed and other politically motivated decisions if "I am even in its mind at all."

Last Thursday, after the market closed, Moody's Investors Service downgraded their ratings on 15 of the world's biggest banks. The move was widely expected and stocks, led by banks, rallied Friday after the second largest drop of 2012 on Thursday on further news of a slow US forecast and global slowdown. In an ironic twist, banking stocks rebounded Friday out of relief that the downgrades weren't worse. Thursday's continuing poor economic news came on the heels of Wednesday's FOMC meeting which failed to deliver on the fresh economic stimulus investors had hoped for.

"It was such a hard sell-off yesterday (Thursday), a relentless sell-off with a lot of downside volume at the close. Coming out of that, you usually get at least some kind of a rebound," said Tim Ghriskey, chief investment officer of Solaris Asset Management in Bedford Hills, New York. "This is just another reminder for anyone who 'used to think that everything was fine' that we aren't in Kansas anymore."

I continue to believe that the market has priced in most of the bad economic data (obviously not the worst case scenarios,) and that all things being equal there is more upside than downside in the short term. The SPY hit resistance at the 50 day moving average and continues to trade in between the 50 and 200 day MA. Our philosophy has been to keep an even balance of long and short exposure until we get a breakout on either side of those, and therefore, I am looking to the banking industry for a pairs trade.

Looking through what crystal ball I have, I am recommending SLM Corporation (NYSE:SLM) for the long exposure based on valuation. SLM Corporation, or Sallie Mae, is trading at a forward P/E of 6.5. Out of the 7 analysts who publish earnings estimates, 4 have revised their expectations upward for Q3 and Q4 and the 2013 year in the last 30 days. SLM has an operating cash flow of $2.88 billion. Analysts are anticipating 18.6% EPS growth this year and 7.4% in 2013. Equally nice is the fact that SLM has beat analyst expectations the last 4 quarters in a row. I recommend buying half the number of shares desired to own at approximately $14.88 and gain exposure to the other ½ shares as well as lower our cost basis by selling the Oct $16 call ($0.55) and Oct $16 put ($1.77) or $2.32 in premium.

Wells Fargo & Co. (NYSE:WFC) has some earnings quality issues going forward which gives rise to my recommendation to short WFC as the other side of the banking pair trade. WFC has a non-performing to total loans ratio of 2.84% which compares poorly to the industry average of 1.9%. In spite of this, WFC seems stingy in maintaining proper allowances for these loans. A large portion of recent earnings have been the result of one time effects, fair value gains, reserve releases, and realized gains from investment securities. Lastly, the balance sheet contains a large amount of level 3 assets which have no established market price and are very difficult to properly price. Furthermore, WFC is trading at a forward P/E of 8.96.

While we all would like to have a crystal ball when it comes to investing we all know that isn't possible. Therefore we have to rely on the best information available and manage our portfolio to prosper in the best of times and the worst of times.

Recommendations:

  • Buy SLM at the market (1/2 the desired # of shares)
  • Sell to open, SLM Oct $16 call (slm12102C00016000) at the market (contracts equal to # of share divided by 100 ... i.e. 100 shares equals 1 contract)
  • Sell to open, SLM Oct $16 put (slm12102P00016000) at the market (contracts equal to # of shares long divided by 100 ... i.e. 100 shares equals 1 contract)
  • Sell to open short, WFC at the market

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.