Banking-Stock Paired Trade: JPM, WFC

Knowing other banks will follow suit, JPM has taken a proactive lead to weaken their competitors. BofA and Wells have weaker balance sheets and more pressing needs. Both these companies are undertaking transformative mergers outside of their areas of expertise. Combine the management uncertainty with the capital needs, a large-scale loan modification is an event they would rather not face. However, JPM has pushed these banks in that direction.

By dictating the pace of the conversation and having the capital needed to take action, JPM will emerge as the strongest bank. The end result will be increased market share and higher future profitability.

The Trade

Based on long-term earnings power, JPM could trade toward $55 in the coming months. With the stock trading near 1.6x tangible book value, we see a stock with strong upside potential, a nice level of current income (3.7% dividend yield) and a reasonable valuation that provides a margin of safety. All in, this is a stock to own for the future.

Buying JPM is a clear choice, but risk management remains a concern. A prudent investor will hedge their risk while attempting to profit from a move higher in JPM's stock price. Since option strategies are uneconomical, I recommend a short position in Wells.

While JPM trades at a reasonable 1.6x tangible book value, Wells trades at 3.1x tangible book value. Further, I believe there are risks in Wells' home equity portfolio that the market has not fully digested. This provides a rare opportunity where a pair trade can offer appreciation on the long side and profit from a short sale as well.

Over time, the valuation of Wells and JPM should converge. By shorting what is dear and buying what is cheap, an investor can manage their risk profile while skewing the portfolio for future gains.