The Point of Maximum Pessimism?

In the glass-half-full department, Warren Buffett, the CEO of investment company Berkshire Hathaway Inc., recently said, “American companies look very cheap compared to investment alternatives,” and promptly took a US$10 billion (5.4%) stake in International Business Machines Corp. In all, Berkshire, led by Buffett and his protégé Todd Combs, spent the third quarter buying US$23.9 billion worth of stocks.

It’s worth noting that in the third quarter, US stock indexes posted their largest quarterly drop since 2008, bottoming at their 52-week lows in early October. Buffett is a believer in buying at “the point of maximum pessimism” (as the late Sir John Templeton famously explained). If Buffett’s actions are any guide, it looks like that point has now come and gone.

But all is not lost. There’s still time to climb aboard the gravy train before it completely leaves the station. We’re thinking here of a sector that’s seen both its 52-week high and its 52-week low in the span of seven months, and is now trading not far from its lows: financial services. Banks, in other words.

Sounds crazy, but bear with us. The eurozone crisis has sparked growing fears of an outright recession in the entire euro area, and this has translated into increasing pressure on credit markets and consequent strains on European banks, which are becoming increasingly concerned about liquidity and access to funding. Consider for a moment that of Italy’s €1.9 trillion (US$2.6 trillion) public debt, about half is held by non-Italian lenders, including many US institutions. And this is tipping point at which credit contagion can spread globally.

With European banks already against the wall and seeking succor from the paper-thin resources of the European Central Bank, US banks came under increasing selling pressure as rating agency Fitch Ratings last week warned that “the risks of a negative shock are rising,” The agency said that some 25% of Tier 1 capital (the benchmark for a bank’s ability to withstand loss) of the five biggest banks in the US is exposed to France – not particularly alarming until you consider that most of that exposure is to French banks, which, of course, are in turn also large holders of sovereign debt, including large helpings of Italian debt.

What has investors really nervous now is that any further escalation of risk through France and Germany might be enough the freeze the veins and capillaries of the credit system – the interbank lending market, the short-term and overnight money market, commercial paper, and all the other swaps and derivatives that keep the financial system liquid. The last credit freeze, in 2008, led to a global recession and a vicious bear market in stocks.

So why even consider a play on banks? For one thing, we’re talking about Canadian banks. The big Canadian banks have no exposure to toxic euro debt. Compared with European banks and US institutions, Canadian banks are once again paragons of virtue. But they’ve fallen by reason of association, not because of any fundamental difficulties with capital ratios or risk exposure.

You could argue, then, that the selloff in Canadian banks is overdone, and a rebound is overdue, especially if international capital flows suddenly take an interest in financial institutions that aren’t on the critical list.

Bold options traders might consider looking for entry points with a view to establishing bullish positions in the Canadian financial sector. The iShares S&P/TSX Capped Financial Services Index Fund (TSX: XFN, Friday’s close $20.25) offers broad exposure to the Canadian financial services sector, comprising all the big banks and insurance companies in Canada. The index is down about 20% from its high – and well into bear territory. A recovery, when it happens, will be sharp and swift.

An alternative, or additional, strategy might be a bullish position in individual Canadian banks that have been beaten down in the general financials retreat. One such is Canada’s biggest bank, Royal Bank of Canada (TSX: RY, Friday’s close $44.42), which is down some 28% from its high. Has RBC forgotten how to be a bank? Is it on the verge of bankruptcy? Hardly. The stock is severely oversold, and upside potential is excellent.

Given the overall environment right now, patience would be a virtue. The payoff might be a while coming. In the meantime, reflect on Warren Buffett, who has never shied away from investing in financial services.

With that in mind, consider buying wither XFN March 20 calls at $1.20 or better or RY April 46 calls at $2.20 or better.