Wells Fargo (WFC) had an incredible run for about 3½ months but has leveled off. Despite the reactionary move when QE3 was announced, it appears lower interest rates are squeezing out profits from the bank and analysts are not as enthused with its forecasted performance through 2013 as they once were. I believe the stock will level off and possibly pull back giving an investor an opportunity at a short-term income opportunity.
Stifel Nicolaus reduced its rating on Wells Fargo from buy to hold, stating that the recent run has about sputtered out in its opinion. It is lowering its EPS forecast for the company because the net income margin compression is only being offset a little by the strong mortgage banking. What is net income margin? It examines how a bank's investment decisions are as compared to its debt situation. Compression of this formula means interest expenses are moving toward a greater cost than what is generated by investments. Lower interest rates tend to compress net interest margins having a negative effect upon financials. This is what Stifel Nicolaus says is affecting Wells Fargo to the point that profits are not offsetting enough to keep forecasts up through 2013.
Wells Fargo all but stated that it expected the decline in the third quarter because the low interest rates are squeezing loan profits. As the spread between what the bank pays depositors and what it gets from its loans gets closer, the bank struggles to increase earnings. Evercore Partners analyst Andrew Marquardt also lowered his 2012 earnings estimate for the bank by 10 cents to $3.28 per share
Wells Fargo is still on a steady, mild climb that started back in June and recently was accented by the QE3 announcement last week. As the stock first started to move up, the MACD was showing a negative divergence. When these formations stand alone in the MACD without support from anywhere else, they tend to show consolidation after a move up, but here I see it is just giving us a mild leveling off. This is hindsight. The move finally leveled out, but the QE3 shot the stock up in a reactionary move. There are no signs that the stock would turn bearish yet. Even the RSI which is moving sideways has stayed above the '50' mark which supports the move up. I believe the stock may remain mildly bullish to neutral for a period, but the reactionary move may bring the stock eventually back down to the '35' level.
The Options Play
Presently trading at 35.90, my observations conclude that the stock has lost steam and could experience a short-term pull back which would be more of a consolidation before it moves up again. For this reason, I am looking at a bearish play for a short-term income play.
- Buy a January 2013 put with a strike price of '36' (priced at $1.91)
- Sell a January 2013 put with a strike price of '35' (priced at $1.44)
- Net Debit to Start: $0.47
- Maximum Profit: $0.53
- Maximum Risk: net debit
- Maximum Length of Play: 4 months
Reasoning behind the Trade
- QE3 Tightens interest rates
- Net interest rate compression not being offset by profits enough.
- Analysts lowering EPS expectations for the bank.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.