Why I’m Betting Against a Famous Short Seller’s Banking Call

Short seller Carson Block of Muddy Waters Capital sparked fears of banking weakness when he spoke negatively about Bank of the Ozarks (Nasdaq: OZRK) at the 2016 Sohn Investment Conference last week. Block announced a short position in the stock, warning that its portfolio of real estate construction loans were overextended in markets that may have already peaked. 

OZRK plummeted following Block’s remarks, leading to the worst weekly performance in the SPDR S&P Bank ETF (NYSE: KBE) since early January.

#-ad_banner-#Investors have turned increasingly cautious on banking stocks lately, but despite a weak April jobs report, economic and lending data favors a bullish outlook on banks. And the increased volatility is presenting a rare opportunity for income investors.

Real Estate Market Looks Strong
While Block hasn’t been able to recreate the success he found shorting Chinese firms, the market still gives him plenty of attention. Shares of OZRK plunged as much as 15% on the day of his presentation, but managed to close with just a 4% loss, suggesting investors didn’t completely buy his logic. ‚Äč

Upon closer inspection, Block’s negative outlook on commercial real estate and banking just doesn’t pan out. The U.S. economy is one of the strongest among developed nations, and there’s no evidence that the commercial real estate market will turn lower in 2016. 

For starters, low unemployment supports retail and office demand, while low energy prices support demand for industrial space. 

Next, low interest rates should continue to benefit the sector. The market is only factoring in an 11.2% chance that the Federal Reserve will raise its benchmark rate as high as 1% by the end of the year, and 1% would still be very low by historical standards.

Lending has continued to grow this year with an annualized rate of 14.7% in construction and land development through mid-April. Commercial mortgages have increased at an annualized 11.4% this year, and delinquency rates are at multiyear lows.

Regional Bank Storm Cloud Has A Silver Lining
One concern weighing on banks recently has been increased regulatory costs from the Dodd-Frank Act and Basel III, which have been especially problematic for smaller regional banks. 

Banking merger and acquisition specialist Tim Johnson told U.S. News and World Report, “The cost to implement the new regulatory reforms is similar for a $500 million institution as it is for a $5 billion one.”

This puts smaller community and regional banks at a disadvantage as regulation costs eat into their profits, but there is a silver lining. 

Bigger regional banks have been acquiring smaller ones, allowing them to spread out the regulatory costs. Banking acquisitions really started to heat up last year with KeyCorp’s (NYSE: KEY) planned takeover of First Niagara Financial Group (Nasdaq: FNFG), along with several other deals in the fourth quarter. 

Experts expect this trend of consolidation to continue, which should be bullish for the sector and KBE. Relatively small regional banks make up almost three-quarters of KBE’s holdings. And half of the 62 U.S. banks held in the fund have a market cap of $3.7 billion or less, making them prime acquisition targets. 

Furthermore, while the Fed is not likely to raise interest quickly, rates will eventually move higher, resulting in higher net interest spreads, which will make the remaining banks more profitable.

KBE has a price-to-book (P/B) value of just 1.05, 17% below the 1.27 multiple on the Financial Select Sector SPDR ETF (NYSE: XLF), which holds shares of larger financial institutions. Not only does KBE look undervalued by this metric, but an increase in general market volatility, and financials in particular, is making a conservative income strategy look extremely attractive.

Volatility Presents A Rare Income Opportunity In KBE
Annualized volatility in KBE has increased to 27% during the past three months, well above the 17% average over the past three years. This, in turn, has boosted option premiums. 

Selling options on funds like KBE typically is not as attractive a strategy as selling options on individual stocks, because volatility usually isn’t high enough to generate big options premiums. But general market weakness and fear over rising rates and the aging business cycle has increased volatility in banking stocks, resulting in some juicy premiums. 

Today’s trade involves selling a covered call. While it may require you to step outside your comfort zone a bit, average traders are using this strategy every day to skim hundreds, if not thousands, of dollars from the stock market. You can get started doing the same immediately by clicking here.

With KBE trading at $31.73 at the time of this writing, we can buy 100 shares and simultaneously sell one KBE Sept 32 Call, which is trading around $1.30 ($130 per contract). This gives us a cost basis of $30.43 per share, which is 4% below the current price. 

If the fund closes above the $32 strike price at expiration on Sept. 16, our shares will be sold for that price. In this case, we will make $0.27 in capital gains, plus the $1.30 we received for selling the call and the June dividend, which should be around $0.13 per share. This amounts to a total gain of $1.70 per share, which represents a profit of 5.6% over our cost basis of $30.43. Since we’d earn that in 128 days, it works out to an annualized return of 16%.

The gain isn’t as high as I usually target on a covered call with individual stocks, but I like the safety I get with a diversified fund, and banking stocks should continue to do well throughout the year. If KBE does not exceed the $32 strike by expiration, I would have no problem holding the shares and selling more calls to generate income.

Additionally, as I write this, investors are skimming hundreds and even thousands of dollars in additional income from individual stocks as well. The money is there for the taking; they’re just beating Wall Street to it. If you want to learn how you can collect an additional $850 a week in income by doing the same, click here.

This article originally appeared on ProfitableTrading.com: Why I’m Betting Against a Famous Short Seller’s Banking Call