E Trade (ETFC) has many issues besides poor fundamental performance, and unfortunately, it has absolutely no control over one of its most serious problems. Since the financial crisis, brokerage profits have been stunted by low interest rates. Brokers make money from the spread between what they pay on deposits and what they earn. During a “Zero Interest Rate Policy” (ZIRP) period, earnings on that side of the business are difficult to drive.
E Trade isn’t the only brokerage with this problem; however, its poor fundamental performance makes the stock more volatile and sensitive to adverse changes in interest rates. Generally, we would expect ETFC’s stock price to just follow Treasury bond yields. Therefore, as rates fall again in October, ETFC should fall as well. However, there has been a divergence in that relationship in 2014 as investors started pricing interest rate hikes into the price of ETFC shares. This has created a situation where ETFC has a lot of interest ‘premium’ priced in and could be extremely overpriced.
Before the 2008 crisis, the largest revenue item on E Trade’s income statement was interest. As a consumer lender at the time, not all of this was from the yield spread, but that was the most important portion of the total interest income stream. As a result of ZIRP, operating margins have drifted from 41% pre-crisis to 17% in the most recent annual report. Net margin has been negative off and on since the crisis so a more detailed comparison is probably not needed.
However, besides a constraint on revenue, the crisis hurt ETFC’s capital structure as well. The company is heavily in debt, which isn’t uncommon for brokerage/banks, but the soundness of your debt is largely a function of the quality of your assets. E Trade is still digging itself out from under a massive portfolio of sub-prime home equity and residential mortgages. The assets weren’t worth what they said on the books so that uncertainty has continued to add to the potential for volatility.
From a technical perspective, ETFC has formed a short-term head and shoulders pattern. This is significant because of two other issues occurring at the same time. First, the head and shoulders pattern formed at a point equal to March’s multi-year high and second, its coming after a divergence between the stock’s price and bond yields. That combination of factors strongly indicate that shares are overbought and likely to fall in the short term.
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E Trade (ETFC) Hourly: Chart Courtesy of eSignal
As you can see in the previous chart, ETFC is nearly breaking its neckline on the hourly chart. Although unconfirmed with a neckline breakout (at the time of this writing) the volume pattern declining into the second shoulder is fairly ideal. A completed pattern should send the stock at least 10% lower to the bottom of its recent consolidation. Much of that depends on the change in interest rates, which seem to be in favor of a decline as well.
The 10-year Treasury bond yield is still slightly above its short-term support level at 2.3%. However, concerns about growth in the near term and more troubles in Europe could send it all the way back to early 2013’s 2% average. A break of support in interest rates should trigger shorts to hold or add to a position on ETFC and should be watched carefully.
While the current environment looks bad for E Trade, this is still a bull market. A short position makes sense as a hedge within a long portfolio if buyers step into stocks again on the dips. Alternatively, pairing ETFC as a short position against a long position in a better performing peer could also be a winner regardless of market direction.
John Jagerson and Wade Hansen are the editors of SlingShot Trader, helping investors capture options profits trading the news by using a proprietary 100% news-driven trading platform that turns event-driven pricing inefficiencies into fast profits. Get in on the next trade and get 1 free month today.
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