How to Squeeze Triple-Digit Profits from Big Banks' Weakness

The next few days are going to tell us a lot about the banking sector; it's earnings season for the marquee "Too Big to Fail" names.

Between this Friday and next Wednesday, we'll see a who's who of big banks step into the earnings confessional, including the likes of JPMorgan Chase & Co. (NYSE: JPM), Wells Fargo & Co. (NYSE: WFC), Citigroup Inc. (NYSE: C), Bank of America Corp. (NYSE: BAC), Goldman Sachs Group Inc. (NYSE: GS), and Morgan Stanley (NYSE: MS).

Of course, this is no surprise. It happens every quarter.

But this earnings season is different – and we have a rare opportunity on our hands...

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Mega-Financials Are Dragging Down the Broader Market

You don't have to look very hard to realize that the large banking sector is one of the reasons why the S&P 500 has underperformed. In fact, the S&P 500 Financials Sector SPDR (NYSE Arca: XLF) has underperformed the S&P 500 in 2018 by about six percentage points (-2.6% vs. +4.5%), as shown below.

And don't get me started how XLF is faring against tech or small caps.

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JPM... WFC... C... GS... BAC... MS – these shares represent more than a third of the XLF, so they need to knock it out of the park in their earnings reports for XLF to have a shot at righting its tilting ship.

What's more, we usually see the big names beat estimates, so the pressure to impress is even greater. Last quarter, in fact, these six companies beat earnings estimates by an average of more that 7%...

... yet the XLF traded flat for a couple of weeks before falling lower.

But let's not stop there: My Best in Breed (BIB) analysis has struck upon a few numbers that should make any remaining bank bulls uneasy.

See, in comparing XLF to all the other exchange-traded funds (ETFs) in my BIB analysis, XLF is in the bottom fifth in terms of relative strength versus the S&P 500.

It gets worse (or better, as you're about to see): XLF has the second-lowest percentage of components (just 13%) trading above their respective 50-day moving averages.

Now, you'd think that short interest in big banks would be on a run higher given this dreadful performance... but you would be dead wrong.

The component-weighted short interest ratio for XLF sits at a minuscule 2.2. That's the lowest of all the ETFs tracked by BIB.

For the bulls, that means there is no help coming from short covering. For the bears, like us, that means there's little risk of it.

I think it could indicate that expectations are high for earnings season, which is the last thing this sector needs.

Here's How We Make Money on This Turkey

I'll close my short-side case with a chart of XLF, which shows a steady decline punctuated by lower highs since the ETF hit a 10-year high in January. The 50-day moving average is declining and is overhead, and the 200-day failed to hold as support in June after providing a foundation twice in May.

To put a fine point on it, the 50-day just crossed below the 200-day in a "death cross." The last time that happened was in September 2016.


Clearly, there's a lot riding on the next week of earnings reports. We'll probably see beats on both the top and bottom lines.

But will it be enough to save the bulls? I think the odds are daunting; there's nothing telling me that the numbers will impress enough to turn this massive, listing ship around.

The inescapable conclusion: The big-cap financials are in for more misery, and piles of it. If you're long here, it's time to cut your losses.

However... We're about to run into what have historically been some of the market's weakest months.

I think there's enough downside in store to yield a triple-digit profit. To capture it, take a hard look at the XLF Sept. 21, 2018 $27 put (XLF180921C00027000).

I'll be back later this week with a couple of high-profit potential "turkeys" that my BIB analysis has pegged for lower lows (and bigger profits for us bears).

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About the Author

Chris Johnson (“CJ”), a seasoned equity and options analyst with nearly 30 years of experience, is celebrated for his quantitative expertise in quantifying investors’ sentiment to navigate Wall Street with a deeply rooted technical and contrarian trading style.

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