5 Bank Stocks: How You Should Trade Earnings

BALTIMORE ( Stockpickr) -- There's a major debate on Wall Street: Are major banks a bargain right now, or are they toxic investments that should be avoided like the plague? With earnings season underway, that debate is getting even more important.

On the one hand, banks are trading at a discount right now. The bargain argument has been enough justification for names such as John Paulson, Steven Cohen, and Warren Buffett to pour billions into bank stocks lately (granted, Buffett's $5 billion stake in Bank of America ( BAC) isn't exactly a high-risk bet).

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On the other hand, banks have a tenuous grasp on profitability right now. Fallout from mortgage issues in 2008 and 2009 continues to factor into earnings, and macro factors are threatening to pull the rug out from the free money banks have been carting in lately. The Fed is running out of options to stimulate the slowing economy. As a result, it's likely that its next step will be to increase the money supply by cutting interest rates on the mountain of excess reserves held by major U.S. banks.

The result would effectively be an end to the risk-free spread banks have been enjoying -- one that forces banks to increase lending to consumers. Put simply, the macro risks involved are significant.

At this point, it's impossible to declare a definite winner in the debate. The economic factors holding a gun to most major banks' heads still haven't completely played out. That said, with bank earnings hitting Wall Street this week, there are attractive technical trades to be made on these names.

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From a technical perspective, the financial sector has shown some important signs of bottoming. That means that investors could be looking at a good opportunity to pick up shares for a short-term trade rather than a long-term, conviction buy.

Remember, technical analysis is a way for investors to quantify qualitative factors, such as investor psychology, based on a stock's price action and trends. Once the domain of cloistered trading teams on Wall Street, technicals can help top traders make consistently profitable trades and can aid fundamental investors in better planning their stock execution.

With that, here's a look at how to trade the earnings on five big banks this week.

Bank of America

Let's start with one of the most hotly contested names, Bank of America ( BAC). BofA announced its third-quarter earnings this morning before the open, delivering earnings of 56 cents per share. That's a significant achievement over the 20 cents of profits that analysts were expecting. Even so, Wall Street's immediate response indicates that there's considerable investor ennui over this bank's numbers.

That's not surprising considering a major chunk of BofA's earnings came from fair value adjustments. Essentially, the bank is getting to decide what its balance sheet is worth, then flow the difference through its income statement. That accounting quirk makes bank earnings considerably less reputable this quarter. So does that mean you should sell off this stock? Not yet.

Bank of America showed traders a near-term bottom at the start of the month, marked by a Japanese hammer candle; the lower shadow on that candle is the ultimate support level that investors need to see hold up this fall. In the meantime, shares look like they could be forming an inverse head-and-shoulders setup right now. That formation indicates exhaustion among sellers, and triggers on the breakout above the tentative neckline in the chart above. Of course, Bank of America will need to make its way back up to that neckline level for the setup to trigger.

A bullish divergence in 14-day RSI is a positive sign for an upside breakout (RSI, like other momentum tools, is a leading indicator), but it ultimately needs to be confirmed by a breakout in price. I wouldn't touch this stock until it breaks above that neckline; when it does, consider a protective stop just below the now-forming right shoulder.

Bank of America shows up on recent lists of the Top 5 Dow Stocks in David Tepper's Portfolio and 10 Bargain Stocks Under $10.

Goldman Sachs

Goldman Sachs ( GS) also released its quarterly earnings numbers this morning. For Goldman, the quarter resulted in a loss of 84 cents per share -- only the second quarterly loss in the firm's 12 years as a publicly traded company. Even though the loss represents a big negative earnings surprise, early trading suggests that investors are taking the loss in stride. Still, I wouldn't be a buyer of this stock just yet.

We last looked at Goldman a couple of weeks ago, drawn in by the falling wedge in shares. Shares broke out of the wedge (defined in orange) last week and have since consolidated, providing an ascending triangle setup with "century mark" resistance at $100 and higher lows.

That $100 price level is the breakout point for Goldman right now; I'd recommend buying shares on a confirmed breakout. Nearby resistance at $110 looks like a solid upside target for near-term traders.

When the breakout does occur, consider a protective stop just below the trend line support level that's underneath the triangle right now.

I also featured Goldman, one of the top holdings of Bruce Berkowitz's Fairholme Capital Management, in " 5 Breakout Stocks to Recoup September Losses."

Wells Fargo

It's a bit ironic, but the best-in-breed banking stock is the one that got hit the hardest yesterday. I'm talking, of course, about Wells Fargo ( WFC). Since the onset of the financial crisis, San Francisco-based Wells has been a standout bank, divorced from many of the problems that have plagued its East Coast peers. From a technical standpoint, Wells Fargo is still the strongest name in the sector.

Yesterday, the firm announced earnings of 72 cents per share, in line with estimates but missing on revenues. Shares tumbled more than 8% on Monday, exacerbated by a bounce off of key 1225 resistance in the S&P 500. But look at Wells' price action, and it's clear that this stock is still holding up. Relative strength has been phenomenal vs. the rest of the financial sector since July; while its peers have trended much lower in recent months, this stock has managed to hold up in a sideways channel, mirroring the broad market.

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Right now, this stock is showing us an if/then trade -- if shares break out above resistance (currently between $26 and $27), then it makes sense to be a buyer. Otherwise, a breakdown below strong support at $23 is a short signal. The stock's attempt at a pre-earnings breakout lacked next-day confirmation; that's something we'll need to see on the stock's next exit from the channel to take this trade.

Wells Fargo, one of Warren Buffett's top holdings, shows up on a recent list of 3 Low-Risk, High-Reward Bank Stocks.

Morgan Stanley

Morgan Stanley ( MS) is due to report earnings tomorrow before the open -- investors should expect a sizable move to follow. Shares of MS have slid 44% so far this year, shoved lower by speculation that this firm could be in serious trouble at the hands of massive exposure to European banks. If management can successfully refute those claims, investor sentiment for the last remaining standalone investment bank could shift dramatically.

From a technical standpoint, the timing is perfect. Right now, shares are sitting just shy of resistance, forming an ascending triangle setup similar to that of Goldman. A major bullish engulfing candle at the start of October sets the absolute support level for this stock right now -- a breakdown below beginning-of-month prices would be a very negative sign.

But a breakout above $18 (the closer move right now) is the buy trigger for this stock. Volatility has been decreasing lately as well, setting the stage for a potential volatility squeeze in shares of this stock. Volatility is cyclical, so the recent decline in share price volatility indicates that a return to high volatility is likely right now. Earnings could be the perfect catalyst for that.

Morgan Stanley, which also shows up on a list of 6 Banks Set for a Third-Quarter Earnings Implosion, was one of 10 financial stocks hedge funds were buying in the most recently reported period.


Finally, let's take a look at Citigroup ( C), the big bank that's closest to a breakout right now. Citi announced its earnings yesterday, posting income of $1.23 per share thanks to the same fair-value accounting adjustments that its peers have been using to inflate their earnings. That lack of fundamental changes is a big part of why earnings had minimal effects on Citi's share price yesterday.

Still, this stock is sitting right below $30 resistance right now -- a breakout above would be a signal that eager buyers have absorbed the pocket of supply that we've seen above that $30 level so far this year. Citi's broken downtrend and apparent reversal in relative strength (versus the rest of the sector) are good signs that support buyers moving into this stock. When a break above $30 happens, I'd recommend a protective stop just below the 50-day moving average.

Ultimately, the debate about whether to buy or short banks isn't likely to be resolved soon -- significant macro and headline risks are going to continue to weigh against valuations for a while. For fundamental investors, less exotic regional banks offer a much more favorable risk right now.

From a trading standpoint, however, bottoming in the financial sector is providing some attractive upside earnings trades in the big bank stocks -- at least for now.

Citigroup shows up on a recent list of 6 Bank Stocks That Could Rally.

To see these stocks in action, check out the Bank Earnings Trades portfolio on Stockpickr.

-- Written by Jonas Elmerraji in Baltimore.


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At the time of publication, author had no positions in stocks mentioned.

Jonas Elmerraji is the editor and portfolio manager of the Rhino Stock Report, a free investment advisory that returned 15% in 2008. He is a contributor to numerous financial outlets, including Forbes and Investopedia, and has been featured in Investor's Business Daily, in Consumer's Digest and on MSNBC.com.