If You Believe in Gloom and Doom

Michael Shulman, editor of ChangeWave Shorts, says the worst isn’t over for the banks and he recommends two big names for short selling.

Bank balance sheets are still a work of fiction and their stocks are still trading at significant premiums to tangible book value.

Meredith Whitney, now head of research at Oppenheimer, led the charge against the banks and received death threats for telling people to sell Citigroup (NYSE: C) at $35. Now, she is telling everyone who will listen that the banks will eventually trade at their tangible book value—and those values are well below current stock prices.

I completely agree, and the recent rally sets up some great positions starting with two banks trading way above tangible book value—Wachovia (NYSE: WB) and UBS (NYSE: UBS). Wachovia will also, eventually, cut its dividend, which sets up a "perfect storm" of downside stock action (and upside put trading activity) to come.

In the meantime, the question is: Do the Fed's actions and the big [recent] market move mean the bear is over for the general market or for the financials?

No. Not even close. Here is why:

Housing prices continue to fall due to excess inventory and a lack of demand. This won't end until the middle to the end of 2009. Foreclosures mean dumping at least another million homes into the market—probably more because resets of adjustable-rate mortgages (ARMs) do not peak until late summer.

Doing the math tells us that's almost two million homes on the market when we need an inventory of half a million to stabilize prices. [And] between 28% and 40% of all potential homebuyers have been removed from the marketplace through the elimination of subprime and Alt-A mortgages. 

The bottom line is that prices will likely stabilize near the end of 2009, we'll see home sales pick up six to 12 months later and home construction will get going near the end of 2010. We are truly de-leveraging—that is, reducing the amount of money lent compared with the assets in place to support those loans. When you reduce loans and credit, you reduce economic activity—and the profits of the lenders.

Fixing the financial system’s balance sheets will take massive injections of new capital and time. This is especially true for regulated banks that must adhere to capital standards.

These banks have to come clean about what toxic waste is on their balance sheets, write that sludge down, and then recapitalize by issuing stock and diluting shareholders, or selling operations or assets, thus reducing the base they need to generate profits.

Either way, shareholders are going to get nailed—and as long as the financials struggle, the market cannot go up except for the occasional bounce. 

Buy the Wachovia July 25 Puts (WBSE-X) under $3.35 and buy the UBS September 25 Puts (UBSUE-X) under $4.60, as well as the Citigroup January 17.50 Puts (VRNMW-X) under $2.75.

Editor’s Note: Short selling is only for very risk-tolerant investors who can afford to lose the money they’re putting in to those trades.