Betting Against Busted Banks

03/24/2009 1:00 pm EST

Focus: STOCKS

Michael Shulman

Editor, Short-Side Trader

Michael Shulman, editor of ChangeWave Shorts, says the recent rally in financials won't last, as their poor fundamentals will hold sway.

With the recent market rally, and particularly the strength in the financials, it's time to short two stocks I've had my eye on for several weeks: Goldman Sachs (NYSE: GS) and Morgan Stanley (NYSE: MS).

Initial public offerings are gone; private equity deals other than workouts are gone; mortgage securitization is gone; credit card securitization is gone, and trading is reduced because core capital to support trading is much less than it was a year ago.

So, it just isn't possible that either company will earn what people seem to be expecting them to earn. Simply put, they will disappoint quarter after quarter, for several years.

The rally we're in now is technically driven, and technical rallies can last for weeks, even longer sometimes, but in any reasonable length of time fundamentals will win out. And in this case, neither company has the fundamentals to support their current stock price.

GS and MS have earnings coming out in the second week of April, and our profits may start coming along then, or may take a little bit longer to play out.

Buy the GS Jan 2010 65 Put (YFTMM) with a Buy Under price of $11.70. Premiums are large, as I'm not alone in my thesis. But a six-month retrenchment by September-halfway to its yearly low at $47-means that we could see a 75%-100% gain. (The put changed hands at over $9 Monday, while the stock closed near $112-Editor.)

Buy the MS Jan 2010 15 Put (WWDMC) with a Buy Under price of $3.75. A six-month retrenchment of the stock halfway to its yearly low of $6.71 could easily get us a double. (The put traded at around $3.40 Monday, and the stock closed above $24-Editor.)

We [also] pocketed gains of 75% and 100% the first two times we shorted the nation's largest issuer of credit cards, Capital One Financial (NYSE: COF), and it is time to do it again.

The stock has run from $7.80 to $13.62 in roughly two weeks. It's time for a pullback.

In January, COF told investors it was forecasting $8.6 billion in bad debt this year, but that was based on unemployment peaking at 8.7%. We'll blow through that percentage in the next couple of months, and recession-driven bad debt will eventually whack the stock.

Longer term, COF has little real earnings power. I believe its outstanding credit lines in 2010 will be less than one-half of what they were in mid-2007. Analysts should wake up to this in another quarter or so.

So, bad debt that's worse than expected, plus earnings power worse than expected-and you have, in COF, a stock that will head south.

Buy the COF Sept 7.50 Put (CKUUU) under $1.90. Take your time and use limit orders only, please. (It traded at around $1.50 Monday-Editor.)

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