2023-05-05 07:35:31 ET
Summary
- As we are at the end of the tightening cycle, I do expect additional relief going forward for the regional banks.
- I am looking for at least a 30% margin of safety, which translates into a ~ $30/share or an FWD P/E of ~ 4.60x.
- Short Gamma option strategies represent a great investment tool.
Investment Thesis
On one side we have Federal Reserve doing its job of fighting inflation, on the other we have regional banks trying to get to the end of the day without going burst. Nothing more than nowadays normality.
Why? Well, we are in the middle of a regional bank crisis which is comparable to the Great Financial Crisis.
And with the value of most regional banks maintaining the downward trajectory, the value of the SPDR S&P Regional Banking ETF (KRE) keeps falling as well. Below you can see represented the performance of the top 10 holdings within the SPDR S&P Regional Banking ETF.
Let's be honest, we definitely saw better times.
However, moments like these represent great opportunities to buy great assets at a discount. It is true that the financial situation of some of the regional banks is not the best one, because they were too greedy during the monetary easing time of the pandemic. But in times like these, a Warren Buffett quote comes to my mind:
Be fearful when others are greedy, and greedy when others are fearful." - Warren Buffett
This quote cannot be more true, overreactions bring opportunities if you know how to gather them. And don't worry, it's true that for the Fed keeping inflation down is important, but financial stability is even more important and they are not hiding it. Federal Reserve keeps providing liquidity to the regional banks through tools like the Bank Term Funding Program (a one-year loan with very good terms in exchange for high-quality collaterals), or the Fed's discount window (which provides loans of up to 90 days), as well as other tools.
Moreover, I also expect additional relief going forward for the regional banks as we are likely at the end of the tightening cycle, with the futures pricing the FED to keep the Federal Fund Rate unchanged at the next meeting and with the subsequent easing going forward. Personally, I do agree with this view as the regional bank crisis will keep doing FED tightening jobs to stay afloat.
CME Group
What about the valuation?
At 2023 forward P/E of ~6.50x, SPDR S&P Regional Banking ETF seems cheap, but it is not. In theory, the P/E of any company that is fairly priced will equal its growth rate. Hence, with the P/E of 6.50x, we should expect SPDR S&P Regional Banking ETF to be growing at about 6.50%, however, the estimates point out at around ~ 5.74%.
This means that SPDR S&P Regional Banking ETF is slightly overvalued and especially in times like these, we want to buy at a discount with a great margin of safety. Personally, I am looking at least at a 30% margin of safety, which translates into a ~ $30/share or an FWD P/E of ~ 4.60x. And since we are expecting a ~ 5.75%, buying SPDR S&P Regional Banking ETF at a P/E of ~ 4.60x, means buying a bargain.
Finally, SPDR S&P Regional Banking ETF pays also a nice and growing dividend yield.
How to capitalize on this opportunity?
Options, options, and again options.
Options offer a great tool to take a directional bet while limiting the maximum drawdown. There are various strategies that can be implemented, the simplest one with a limited downside is selling a vertical spread, or if you have a greater risk appetite and you are willing to take the delivery, selling cash-secured puts. Both are strategies that will benefit from the falling Gamma, with the former being the safest among the two but also with a smaller potential reward.
Personally, I sold a few put options with a strike of $30 and a June 16, 2023 maturity date. Even if I do expect some additional downside volatility, I am at the same time comfortable with taking the delivery at $30/share as I will have enough margin of safety on a fundamental basis.
Conclusion
It's true that cheap can always get cheaper, and it is important to keep it in mind, but it is also true that it is important to take the opportunity when we see one. In my opinion, the opportunity offered by SPDR S&P Regional Banking ETF is one of them.
From a fundamental standpoint (on a P/E basis), SPDR S&P Regional Banking ETF is slightly overvalued and it doesn't offer enough margin of safety to cover the investor from the risk of trying to catch "a falling knife". However, thanks to options it is possible to buy the shares at the "right price" while keeping our maximum drawdown capped (i.e., vertical spread).
For further details see:
KRE: A Key Level To Be A Buyer