JPMorgan: When Is It Time To Buy?

JPMorgan (JPM) was the best house on a bad block. While other money center banks just fudged numbers to get profits, JPMorgan's profits were true earnings. In JPM's 10-K:

If we wanted to increase this quarter's or next quarter's profits, we could - and we could do it easily. How? By cutting marketing expenses by $500 million or eliminating another $500 million of investments in technology, training or systems upgrades. We also could add another $1 billion to our profits by increasing our interest rate exposure or credit risk. But this is not the way to build a healthy and vibrant company for the future or to produce what we would call 'quality profits.'

Even the federal reserve agreed. After running a stress test on JPM that included:

Unemployment goes to 13%.

Gross domestic product drops 8%

Home prices drop 20% from today's levels

Trading, capital and credit markets perform even worse than they did in the last crisis

The federal reserve found that JPMorgan would still be able to maintain Basel 1 capital of over 5%. That's why JPMorgan was allowed to increase dividends by 20% to $1.20 a year in March.

But after the infamous London whale disclosures on may 10th, everything has changed. One trader, AKA the "London whale," basically set up $100 billion dollar plus short position on an esoteric index CDX.NA.IG.9 in the guise of doing hedging. Unfortunately, the trade went wrong and there was no hedge to counterbalance the loss. JPMorgan had to announce a $2 billion loss.

The true loss is still not known. Because now everyone knows JPMorgan's positions, the number could go higher. CEO Jamie Dimon says possibly $4 billion. Other analysts say $6 billion. The ultimate question though isn't how much the losses are for this one trade (because it is a drop in the bucket versus JPM's financial resources) but what the future ramifications are. The cockroach theory basically argues that there are similar whale trades or 'cockroaches' in other banks and that it is only a matter of time before others manifest themselves. JPMorgan will be viewed more through the lenses for creative accounting type banks such as Bank of America (BAC) than with staid banks like Wells Fargo (WFC). Harsher regulations and a Volcker Rule with more teeth is almost a certainty.

Fundamentals

At the closing price of $33.07, JPMorgan has a dividend yield of 3.75% and a forward p/e of 6. The tangible book value for JPMorgan is still around $32. It had earnings growth of 13% this year and expected 20% next year. In terms of fundamentals, JPMorgan looks downright cheap. For long-term investors, a dividend yield of close to 4% for a great stock like JPMorgan has got to be great news.

However there are downside risks

If Greece does leave the euro, there are a lot of fat tail risks that could manifest themselves. There might be a run on banks, and although the ECB, Federal Reserve, and IMF should intervene to prevent it, you never know. Lehman Brothers happened. Something similar can happen. While American banks should theoretically be better than European banks, their derivative exposure will transfer a lot of stresses to them.

The $15 billion dollar buyback has been suspended, which reduces the demand side of the equation.

There has been a reduction of confidence in JPMorgan's risk management. This will most likely reduce short-term p/e for a while.

Despite this rally, the overall market is pretty weak, and while SPX right now has a pretty firm floor at 1265-1280, if it falls through, it will most likely be a trap door for a while.

Conclusion

The safest trade would be to wait until JPMorgan reinstates its buyback. Given that it might take a year or more for JPMorgan to unwind its London whale position, this event might not be anytime soon.

Another 'safe' trade would be to buy at $28 knowing that a lot of other people will buy there as well. With the momentum and downside risks of JPM, this might happen sooner rather than later.

The final one would be to buy now, and hold on to it for the long term and collect the near 4% yield. A lot of people own JPMorgan - Warren Buffett's personal account is one of them, and they generally bought at higher prices.

Disclosure: I am long JPM.