How Rising Rates Could Deliver Us A Quick 31% Gain

Jared Levy's picture

Friday, January 20, 2017 - 12:00am

by Jared Levy

While 2016 may have been the year for the FANG stocks, (Facebook, Amazon, Netflix and Google), a new year and new president mean there's now a new group to focus on. According to researcher Tom Lee over at Fundstrat Global Advisors, 2017 is going to be the year of CRAP stocks.

Although the term conjures a gross image, Lee and his team may actually be on to something in their latest research.

Unlike the specific stocks called out in FANG, CRAP stocks are sector-oriented. The term stands for computers, resources, American banks and phone carriers.

While I agree with his bullish logic on these sectors, it's the American banking system that interests me most, and that's where I've selected as the next target for my Profit Amplifier readers and I to trade.

Unlike the other sectors, banking stocks can win in several different scenarios, where the others will most likely need a consumer or economic boom to succeed. If all the Trump rally hype turns out to be true, then banks are sure to benefit as consumers spend and borrow more. But even without a full-blown, Trump-fueled economic turnaround, there are still two very strong catalysts that should be more than enough to move the sector -- and today's target -- higher.


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Efficient Banks And Ginormous Reserves Multiply The Interest Rate Effect
A decade has passed since the housing meltdown led us into the Great Recession, an episode that pushed most banks to the brink. Many were forced to dramatically change their business, consolidate or fold completely.

During the turmoil, large banks merged with brokerages to gain access to bailout funds provided under the government's Troubled Asset Relief Program (TARP), giving them a much-needed lifeline and additional income streams.

As banks were working to claw their way out of the abyss, lawmakers targeted them for dramatic reforms, which stifled them further. President Barack Obama signed the Dodd-Frank legislation into law on July 21, 2010, and essentially stripped away many of the freedoms banks had enjoyed after Bill Clinton empowered those same banks back in the 1990s.

The new laws have made banking a very tough sector to operate in, and many small and midsize banks were faced with two choices: merge into larger entities... or fail. By 2015, the top four banks controlled 51% of the industry's total assets.

While that number seems impressive, the biggest banks -- JP Morgan, Bank of America, Citigroup and Wells Fargo -- haven't grown as much as you might think.

Sector earnings and market caps have grown... but mostly through an increase in deposits and through clever cost cutting and consolidation efforts.

In the new, highly restrictive environment, banks have had to strip out all their operational fat, cut toxic or risky assets and become lean, moneymaking machines. They closed hundreds of branches and transitioned to digital and mobile platforms that cost one-tenth of what it might take to staff a branch. For example, the company my subscribers and I recently targeted for our trade went from having more than 6,000 branches pre-crisis to roughly 4,600 today.

But these very survival necessities have positioned them for the perfect earnings windfall -- one that I don't think many investors understand.

Interest-bearing deposit accounts in the country's four largest banks ballooned by nearly 70% from 2009 to 2014 (above chart) and have continued to grow, while loan growth (shown in the below chart) has been relatively stagnant, far less than pre-crisis levels.

When banks have more money in deposit than is required to make loans, banks have what is called "excess deposits" or "reserves."

Reserves create safety (we all like that), but they are also counted as liabilities on the balance sheet. When reserves fall, liabilities drop and earnings per share (EPS) increases.

But large excess reserves also create the potential for inflation disaster. This is why reserves may fall quicker than most expect and why banks will make much more money during a rate increase than most investors realize.

Inflation Control Equals Additional Profits
American banks currently have $2.4 trillion in reserves. This equates to roughly 60% of the $4 trillion in U.S. currency pent up in bank deposits. And these reserves were built up from zero in just the past decade.

Since banks have a 10% reserve requirement (meaning, they are free to loan out the other 90% of deposits), they could easily triple the amount of liquidity (money) in the U.S. economy and spur some serious inflation -- and that is one thing the Federal Reserve does not want.

To counter this potential disaster, the Fed needs to raise rates at a relatively fast pace to reduce reserves and get the inflation risk down.

This action will benefit the big banks and its peers in a big way. This might seem like common sense now that you know about it, but it's a little-known fact that most investors don't fully understand -- if they even know about it at all.

How We Trade This Idea
Our Profit Amplifier trade -- Bank of America (NYSE: BAC) -- is flush with cash ready to be deployed. As rates increase, the company's profitability increases even faster. The bank is perfectly positioned to surprise investors as it reduces cash and enjoys an increasing rate environment.

But I'm not the only one expecting good things. Analysts at Goldman Sachs see what I see, and recently increased their price target to $27 -- about 20% above recent prices.

But for the trading strategy my subscribers and I use at Profit Amplifier, we don't need shares to double or even climb all the way to $27. All we're looking for is a 10% move higher to $25. The $25 mark is a common, round number that sits comfortably below Goldman's new target. And by using a simple call option, we can amplify that 10% move into a nice 31.6% gain.

I'm saving the specifics of this trade for my Profit Amplifier subscribers. For each trade, I provide readers with clearly laid-out trade that can amplify potential gains without substantially increasing downside risk. And in today's low-rate environment, this type of strategy is more crucial than ever. If you'd like to learn more about this trade and the others I'm currently recommending, I invite you to follow this link.

Jared Levy does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.