October 14, 2013 - Banking for Steady Returns
The U.S. Federal Reserve is going to keep printing money and I am not just talking about the new designs on the $100 bill. Janet Yellen was nominated by President Obama to take over Ben Bernanke's job as the head of the Federal Reserve. This is a big deal. As head of the Federal Reserve, she will lead the bank that sets interest rate targets in the most important economy of the world. She is arguably as important as the President, since elections are often decided by the economy and economic growth is decided by interest rates. With the quantitative easing program buying a lot of US debt, interest rates at historic lows and cheap money fueling the stock market boom, risks are high.
The economy is more fragile than many would like. Many people would like to find jobs and get back to work. Others want to see them working so the unemployment rate falls. The government shutdown is more about politics than anything else. Notice how they waited all summer to shut the government down the same week that the Affordable Care Act kicks in? Climbing US debt, the debt ceiling, and the budget battles that will be coming soon may be more important. Interest rates will need to rise at some point, how soon and how much and how fast are all important issues to decide.
Janet Yellen is experienced with economic issues. She has years of economic and banking experience at the Federal Reserve Board. From her very public statements, it is a good guess she is going to continue the easy money policy of Bernanke for some time. There should not be any big surprises here.
Ultimately, there are a lot of consequences with regards to any decision the Fed makes. Whether you like the quantitative easing our government has been doing or not; it has benefited the stock market. People are able to borrow money and buy dividend-paying stocks. The money is cheap, plentiful and times are good in the market. When the money gets more expensive and interest rates rise, people will sell these positions and drive stock prices lower. There will be a rush to the exit at that time as everyone tries to sell while prices are still up.
That dip should be temporary and long term the markets will adjust to any changing circumstances. However going forward for the next 1-2 years it appears that easy money will continue until unemployment falls. This is good for stocks, the stock market and companies that trade stocks.
One company that may have a disproportionate amount to gain is BK. While all of the banks like cheap money, the Bank of New York Mellon Corp is a bank that specialized in securities trading and wealth management. This makes it different from a lot of the other banks. It trades stocks and securities with over $16 trillion in assets under management. That means the company is so big, its customer's assets are basically equivalent to a full year's production of everything we make in the US. It is one of the top three banks in most of the areas it specializes in. The bank makes many off trading, management and other financial fees charged to clients. With a stock market staying in rally mode; this bank should continue to make money.
Chart courtesy of www.stockcharts.com.
Earnings have been fairly steady over the last three years at BK, even with a rally in the market. The stock has pulled in between 2.03 and 2.11 a share over the last three years with expectations of 2.37 this year. Over the last two years the stock has been in an uptrend rising from about $20 to $30 a share. The stock pays a 1.97% dividend yield -paying $0.15 each quarter. There were some losses (-0.23) reported in the first quarter of the year, but the second quarter earnings of 0.71 made up for them. Analysts will be looking for $0.63 a share when it reports on October 16th.
With the stock trading near 30, selling the January 31 options looks tempting. One can buy the stock for 29.78 and sell the call for 0.97 giving 2.5% of downside protection, a 6.7% assigned return and a 34% annualized return rate (for comparison purposes only). One would enter the trade for a net debit of 28.81. The stock has been appreciating, and this trade is planned to allow it to continue to rise and to capture that appreciation. Going from 20 to 30 over two years takes a 23% rise each year. This trade is targeting a 34% rise, but with the extra returns there is also extra risk that the stock may not rise. If the stock falls instead of rising, you can be left holding the stock which is why covered call should only be done on stocks you wouldn't mind buying at a discount and holding for the long term. BK is a stable bank stock doing well because of the market rally. All the trading activity that is going on is driving business and management fees. While the stock is appreciating, it has been doing so a measurable pace, and so a covered call can look attractive on it.
Banking and the banks should be a safe bet as there is too much riding on an easy money policy to consider a significant change in action now. Obama and the Fed are printing money and the market is enjoying the benefits of this cheap money. BK is a more stable banking stock than some of the other banks and should do well with a new head of the Fed.