Why the bank trade in 2018 will hinge on the ‘rule of 3’

With Friday’s non-farm payrolls report out of the way, the market’s attention is turning to bank stocks as we await a big week of earnings.

Next week, J.P. Morgan and Wells Fargo report earnings Friday before the opening bell. Investors are generally quite bullish on the stocks at this point, anticipating they will reap rewards from the Trump administration’s proposed tax plan, which should help the sector lower its own tax liability and also spur corporate investment. The anticipation is that new capital depreciation rules will increase investment budgets and, by extension, lending.

But bear in mind: The success of the bank trade will ultimately depend upon the rule of 3 in 2018. Will the Fed raise rates three times? Will gross domestic product grow at a rate of 3 percent?

If both of those assumptions fail, then bank stocks could see a nasty correction as the yield curve continues flattening and threaten the lending institutions’ profit margins.

Of two of the banks reporting earnings next week, J.P. Morgan enjoys a much better reputation and a more dominant market position than Wells Fargo, so investors wary of any correction in the sector may want to consider a pair trade.

By going long an equal amount of J.P. Morgan stock and short an equal amount of Wells Fargo, investors could benefit from J.P. Morgan’s operational relative strength while avoiding any turbulence in the overall market.