As the economic outlook dims, I have a bear put spread play against the Financial Select Sector SPDR exchange-traded fund (XLF) .
Before I get to the trade, however, let's look at the "why." The banking system and financials in general are facing significant and growing challenges on multiple fronts. Fast rising interest rates over the past year and a half have resulted in large unrealized losses on many banks' bond portfolios. This was the key factor that led to the demise of several prominent regional banks earlier this year including Silicon Valley Bank and First Republic Bank.
In addition, it seems the situation for commercial real estate -- "CRE" -- worsens by the weak. CRE values are crumbling in many parts of this sector, especially on office and retail properties. "Jingle Mail" is starting to occur on a commercial basis, not unlike on a residential basis that preceded the Great Financial Crisis. Every week or two, another property is acquired by its primary lender for 30%, 40% or 50% of its official appraised value.
Delinquency rates continue to rise at a rapid clip in 2023 on commercial bank mortgage securities, or CMBS. This particularly hurts regional banks that provide approximately 70% of the funding to the commercial real estate industry. This situation is likely to get much worse before it gets better, as some $2.5 trillion worth of CRE loans need to be rolled over at much higher interest rates over the next three years.
Since the Federal Reserve ended its long standing "zero interest" rate, ZIRP monetary policies early in 2022, initial public offering, special purpose acquisition company deal and merger and acquisition volumes have dried up. This has resulted in major drops in fee income at investment banks like Goldman (GS) , as well as tens of thousands of layoffs across the industry. Average 30-Year mortgage rates are at their highest levels in over two decades. This has resulted in a sharp drop in mortgage volume, a key earnings driver for several major banks as weekly mortgage applications have recently hit 28-year lows.
Consumers are increasingly strained, which is starting to result in increased delinquency rates and write-offs. The resumption of student loan payments after a more than three-year layoff will also put some 40 million Americans under additional financial pressure.
The interesting thing is all this is happening within an economy that is seeing 2% gross domestic product growth with under a 4% unemployment rate. What happens if the country enters a recession? This seems increasingly likely, given the recent cracks in the labor market, where full time jobs have now declined for the last two months and every single jobs report has been revised down so far in 2023.
Let me go on the record saying I don't see a 2008 scenario washing across the financial sector. But a recession that badly hurts earnings across the industry appears to be more than a likely event over the next year. Given that, I want to add some portfolio insurance for the long positions in my accounts should an economic contraction unfold in the coming quarters. Fortunately, with volatility low, this is relatively easy to do via bear put spreads against the Financial Select Sector SPDR Fund.
Option Strategy:
Using the September 2024 $30/$25 strike put pair on XLF, execute bear put spreads for a net debit of $0.50 to $0.55 a share. If the ETF drops by 28%, you could see a gain of nine or 10 to one . Approximately a 15% decline makes the trade break even. This might seem like a big drop for an ETF, but if we see a significant recession over the next year, financials will get hit hard.
