How a $30 Billion Blunder Could Lead You to Massive Profits

David Sterman's picture

Tuesday, May 22, 2012 - 10:37am

by David Sterman

Reckless actions will get you punished. That's what JP Morgan's (NYSE: JPM) CEO, Jamie Dimon, was surely thinking after he learned that a key employee at his firm had lost roughly $2 billion on an ill-conceived trading strategy. In fact, his firm's losses from this debacle could easily reach twice or three times as much as that initial amount, causing Dimon more sleepless nights ahead.

But was this misstep really worth $30 billion? That's the stunning amount of market value that this venerable bank has lost in recent weeks since the trading scandal was announced. Shares have been tarred and feathered so badly that they now trade below tangible book value.

Twin pressures
That steep drop in shareholder value also likely stems from a pair of other factors. First, the trading losses make it more likely that the entire banking sector will be put in handcuffs when it comes to risky trading for the firms' own accounts. The Volcker Rule, banking legislation which was likely to be passed by 2014 in a watered down version, now looks set to have some real teeth in it. Still, the hit to profits will not be as great as some would have you believe. These folks believe that any regulation is inherently evil, and they should understand that a more tightly-regulated banking sector reduces risk and expands the valuation of key banking franchises.

The second factor: Greece's potential loan default has spooked investors and analysts, as potential exposure to that country and neighboring weaklings is being assessed. Kicking off the trading week, analysts at JMP Securities, for example, slashed ratings on all of the major banks it follows.

Yet with the large cap banks now down 21% in the second quarter (compared to an 8% drop in the S&P 500), that downgrade looks to me to be an after-the-fact reaction. Indeed, many bank stocks were quite inexpensive before the downdraft began. And in some instances, they are now stunningly cheap.

Take Citigroup (NYSE: C) as an example. Tangible book value has been steadily rising (and will likely continue to do so), and shares had been slowly rising, closing a gap that had grown too large. Now that discount to tangible book is again massive. Shares traded for 73% of tangible book value at the end of the first quarter of 2012, but shares now trade for roughly half of recent tangible book value.

It's almost unbelievable. But it's also a rare opportunity to buy a steadily-healing global giant that's trading like it was in the darkest days of the recession. That remains the main source of appeal to me with this stock, which is why I still expect it to deliver big gains to my $100,000 Real-Money Portfolio.
 
How bad can Europe get?
Putting aside for a moment the JP Morgan debacle and the pall it has cast over bank stocks, investors want to assess how much Europe may affect U.S. banks. Only Bank of America (NYSE: BAC) has significant un-hedged exposure, as European loans represent 7% of the firm's Tier 1 Capital. For Citigroup and Morgan Stanley (NYSE: MS), that figure is just 2%. Meanwhile, Goldman Sachs (NYSE: GS) and JP Morgan are so well-hedged against a meltdown among the PIIGS (Portugal, Ireland, Italy, Greece and Spain) that they actually would modestly profit from a default crisis.

The real risk to these banks, and why they could still fall further in the short-term, is largely psychological. Any deeper crises in Greece and elsewhere would lead to a short period of instability in global financial markets that leads to an investor panic. In effect, investors are selling bank stocks in anticipation of such a moment, though it's not clear if it will ever come to pass.

The coming sentiment change
At this point, one of two things will happen to these banks stocks. First, they might fall a bit more, leading their already-cheap valuations to bring in a new flock of deep value investors and a fresh cycle of analyst rating upgrades. Or second, they simply stay at current levels until the current storm passes (or just peters out if Greece and the rest of Europe come to terms), at which point these bank stocks would likely see a solid relief rally.

One analyst isn't waiting. Citigroup's Keith Horowitz has just promoted JP Morgan to the firm's "Top Picks Live!" list. Now that shares have fallen from $45 in early April to a recent $33, Horowitz's $45 price target implies a round-trip trade (and 36% upside). He has run through the various guesses about how large the bank's losses will be when this infamous trade (initially seen as a $2 billion loss) is fully digested. He's convinced that current whispers of $5 billion or even $10 billion in losses are far off the mark. "We clearly see an attractive risk/reward as we believe a lot of investors' concerns have gotten to extreme levels," he wrote. At this point, he expects shares to post a nice rebound once management is able to fully quantify the firm's exposure.

Risks to Consider: The Greek crisis is coming to a head, and a default could come as soon as next month. That's why it makes sense to nibble on these deep value stocks and be ready to aggressively add to that position once the crisis is at full-bore, or if it appears there won't be a crisis.

Action to Take --> A clear disconnect has emerged for these bank stocks: They've gotten steadily healthier in recent years, as seen by rising Tier 1 Capital ratios, expanding book value, rising profits and a moderately healthier U.S. economy; yet they are again trading at distressed levels, as if the U.S. economy is headed back to the dark days of late 2008 and early 2009. This disconnect helps set the stage for a solid buying opportunity -- if you can shoulder possible near-term losses in exchange for potentially robust long-term gains.

[Note: I've told readers of my $100,000 Real-Money Portfolio that I personally think a stock like Citigroup could easily double in a year or so, making it my top pick in the sector. To find out more about my top stock ideas, and to receive them in your email completely free for a limited time, go here to sign up.]

David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC owns shares of C in one or more of its “real money” portfolios.