Over the past few years, I have made huge profit’s trading the Federal Reserve’s stress tests of the major US Banks. In the past, I have been a trader of Bank of America (BAC), Morgan Stanley (MS), Citigroup (C), and Fifth Third Bancorp (FITB). The Fed released the results of the test itself today, including the Tier 1 capital ratios of all the 19 big banks. Not surprisingly, 18 out of the 19 banks “passed” the test, meaning they met the threshold of a 5% ratio under stress test conditions.
The purpose of the stress tests is twofold. First of all, the stress tests are designed to assure the Federal Reserve that the banks have enough readily-available (Tier 1) capital to withstand another financial crisis such as the one that occurred in 2008. Basically, the stress test is like when you and your 19 brothers (Bank of America, Wells Fargo, Citigroup, etc.) have to take your report card home to get signed by your parents (the Federal Reserve) to show that you are doing the work you are supposed to be doing at school. So purpose number one of the stress tests is to prevent a future catastrophic financial crisis. But another major (unstated) purpose of the stress tests is to maintain public confidence in the big banks. Many people’s trust in the big banks was rightfully damaged in 2008 when it became all-too apparent that, just because a bank has a billion dollar market cap and has been around for 50 years, it doesn’t mean that you can trust that it isn’t making reckless decisions behind closed doors.
In 2009, the economy, the stock market, and the big bank stocks were on shaky ground. Bear Stearns and Lehman Bros had shown investors that there was no such thing as “too big to fail.” When it was announced that the Federal Reserve was going to be stress-testing the major banks, I sat down and thought about what the possible outcomes would be. First of all, expectations could not have been any lower in the market for the banks at that time. When expectations are in the basement prior to a catalyst like the stress test, a stock starts to look like low-hanging fruit to me. Investors had no idea how badly the banks balance sheets looked at the time, and they assumed the worst. In the stock market, the only thing worse than bad news is uncertainty, and I knew that, good or bad, the stress test would shed some much-needed light on the big banks’ situations. Here is a passage from my upcoming book Beating Wall Street with Common Sense: How I Achieved a 400% Return from my Dorm Room:
On Friday, April 24, 2009, I was as uncertain as everyone else about the short-term success of the banks. I did not know whether or not BAC or C would pass the stress test, or if the Federal Reserve would require them to raise additional capital. However, one thing I DID know was that the results of the stress test would be released in early May. And I knew that as soon as the results were released, every single person with a TV, a computer, or a newspaper that was previously uncertain would now be certain, one way or another. My idea was that the 19 banks being tested were trading at the time as if they had already all flunked the stress test miserably. Even if all of the banks failed the stress test and needed more capital, investors would have a sense of relief because the uncertainty would be gone. In my mind, good or bad, the stress test results would provide clarity that would eliminate the fear of owning bank stocks.
I decided to try to trade my idea. However, the problem I had with buying another megabank like C or BAC was the problem of diversification. I wanted to own another bank, I wanted it to be one of the 19 banks being stress tested, and I wanted it to be as different as possible from Citigroup and Bank of America. I decided on Fifth Third Bancorp (FITB). FITB was a much smaller regional bank that I believed was more isolated from the games the big banks were playing during the housing bubble. Mind you, I had no proof to support this belief; it was simply a hunch I had. But the important thing to remember was that, in my mind, there was no wrong answer. I believed that each of these 19 banks, no matter how bad the test results, would likely see a rise in share price after uncertainty had been eliminated.
On Monday, April 27, 2009, I bought shares of FITB at $3.64 per share. By the close of the trading day on the following Monday, FITB was over $4.50 per share, a gain of nearly 25% in a week. On Thursday, May 7, the Federal Reserve released the results of the stress test. Ten of the 19 banks “failed” the stress test, indicating that they would need to raise additional capital. Among the flunkees were C, BAC, and FITB. Fifth Third needed to raise an additional $1.1 billion dollars, which was a lot of money for a relatively small regional bank. So what happened to my bank stocks? The week of the stress test results, C and BAC jumped over 30 and 60 percent respectively! And FITB? My FITB shares rose a whopping 110% in one week! All of these banks had “failed” the stress test, but the results were not the end of the world, and investors were relieved to see some light being shed on the situation. At the time, I was well aware how absurd it was that a stock would double in a week, and I was worried that there would be selling pressure to drive FITB’s share price back down. On Friday, May 8, less than two weeks after I bought my FITB shares, I sold them for $7.28. In case you didn’t notice right away, that is exactly TWICE what I paid for them! I had doubled my investment!
That FITB trade in 2009 was one of the best trades I’ve ever made, but unbelievably it’s not even one of the top two trades I’ve made involving stress tests! To read about how I’ve taken advantage of the market psychology surrounding the stress tests since 2009, you’ll have to check out my book. Details coming soon!