Market Overview

Buy Regional Banks, Sell Investment Banks (JPM, GS, MS, KRE)

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Investors looking for a hedged way to invest in financial stocks should consider a pairs trade where investment banking stocks are sold short and regional banking stocks are bought using the SPDR KBW Regional Banking ETF (NYSE: KRE).

The business models of companies like Goldman Sachs (NYSE: GS), J.P. Morgan (NYSE: JPM) and Morgan Stanley (NYSE: MS) are coming under significant pressure as a result of a very dismal trading environment and a lackluster investment banking atmosphere.

It seems possible that a long-term secular change is underway on Wall Street, which will pressure revenues for some time to come. The trading business is very, very depressed right now, as volumes are at multi-year lows. Furthermore, despite the recent pick up in M&A, the investment banking side of the business is no where near what it was prior to the financial crisis.

Regional banks, on the other hand, are benefitting from increased asset and credit quality while remaining insulated to a large extent from the trends affecting Wall Street investment houses. Furthermore, by engaging in a pairs trade, investors can gain access to a segment of the financial sector without taking on significant market risk.

This trade would be executed by buying the KRE and selling a corresponding aggregate amount of Goldman Sachs (GS), Morgan Stanley (NYSE: MS), and J.P. Morgan (NYSE: JPM). The trade will show a profit, if the KRE outperforms the combined performance of these three stocks.

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