As bank earnings approach, a market anomaly emerges
Earnings season begins next week, and as usual, the big banks are leading the way. What the tape tells me is that over the last four weeks the relative rotation of financials relative to the broad market has been improving.
Information technology, which has been the market leader for as long as anyone can remember, plateaued four weeks ago and has begun to weaken over the past three years. Relative power is not achieved overnight; it tends to develop over time and sometimes gives false signals (watch the attached video, I’ll show you what I mean). But capitalizing on this requires some foresight and potential catalysts, and we’re about to get a few.
The Financial Select Sector Index trades at approximately 15.5 times forward earnings; That’s about a lap and a quarter cheaper than it will be in 2024. Is this the cheapest financial data ever? No. But this is a group that has tripled adjusted earnings per share over the last decade. If the forecasts become clear based on the results of this season (and the improvement in the dynamics of credit, capital market activity and net interest shows this), this rate looks increasingly attractive.
The most talked about topic in the last two years has been artificial intelligence, and as we see, this is a stock picking exercise. You must identify winners and losers. Overall, hardware has been the winner lately, while software and services have been the losers. Financial matters, meanwhile, are a little simpler: If the economy is doing well, it usually is.
The AI narrative of the technology requires you to accurately predict which companies will capture the spend, how big it will be, how long it will take, and whether it can be successfully monetized. Finance doesn’t want this from you. These are a leveraged play on nominal growth itself. You don’t need to determine the winning horse or, worse yet, find the needle in the haystack; just have the haystack.
What makes this feasible now is that the implied correlation is historically low. I mentioned implied volatility earlier, which is the way options traders think about option price. Implied correlation is how option traders think about the price of options in baskets of stocks relative to the price of options on stocks in those baskets. When is the “implied correlation” high? This simply means that the option prices on the baskets are higher than the option prices on the stocks they contain. When is implicit correlation low? The exact opposite is true. Simply put? Options on NDX, SPX and sector indices are a better deal than single stock options.
Financial Election Sector SPDR, YTD
Since option premiums are cheap in baskets, this is a time to buy options directly on ETFs rather than reflexively spreading them or trading single names. With XLF trading near $55.50, 56 August calls can be purchased for roughly $1 (under 2% of the ETF price) for six weeks of exercise, covering the heart of earnings season.
Trade
- Buy XLF 56 August Calls
- Buy 56 August calls for ~$1.00 (XLF ref: ~$55.50)
- Maximum Gain: Infinite
- Maximum Loss: $100
- Skill Level: Beginner
