Short the Street!

02/21/2008 12:00 am EST

Focus:

Michael Shulman

Editor, Short-Side Trader

Michael Shulman, editor of ChangeWave Shorts, says Wall Street firms remain vulnerable to the credit crunch—and he thinks two of their stocks should be shorted.

Everyone on Wall Street has been looking towards the Federal Open Market Committee to fix lenders’ problems with interest rate cuts. And even though it's not the FOMC's job to clean up the mess on Wall Street, it has stepped in to provide much-anticipated cuts. 

But, while investors want to see even more rate cuts, the bullishness that typically accompanies Fed action is having less impact each time around. And there are no guarantees that any further action can even provide enough relief to these troubled companies.

The credit squeeze is tightening, and all signs point to further pain on the horizon. A recent report says loans for private financings are down 86%. This is bad news for bank profits and bank stocks.

[So,] if the banks aren't making money, then let's short 'em and make some profits of our own!

We've had some great success with shorting the financials, although we stepped out for a while in January when the Fed made some emergency interest-rate cuts that served to give a short-term boost to the ailing stocks.

However, I believe the wait between now and the next Fed meeting in March will be hard on the segment. I also think the Fed will disappoint the market and cut less than expected the next time around. And this gives us several weeks to not only watch the credit markets continue crumbling, but also to make some sweet short-side returns along the way.

Thus, I am recommending you buy put options to short two investment banks—Bear Stearns (NYSE: BSC) and Merrill Lynch (NYSE: MER)—as I see a downturn in their core businesses with lending and deals drying up.

There are many other investment banks that could be shorted, but I believe the stocks of these two are most vulnerable.

Merrill Lynch is gong to be hit by lower profits due to reduced lending, so let's get ready to profit from the next wave of bad news by buying the MER July 47.50 Puts (MERSW-X) below $4.60. (They traded at $4.28 Wednesday—Editor.)

As for Bear Stearns, more bad news is coming, not to mention the remote chance of a catastrophic federal investigation and indictment. Buy the BSC July 75 Puts (BVDSO-X) under $10. (They traded at $7.30 Wednesday—Editor.) This is a more expensive play than our typical recommendation and these are the most fairly valued puts available. And when the stock starts sliding again, we'll be positioned for it.

These are not positions for the faint of heart and are very high risk—a surprise rate cut will kill these positions, (among other things—Editor.)

However, if the Fed stays at bay—and as the bad news continues to play out in the credit markets—we could have some nice winners on our hands in a relatively "short" amount of time.

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