The Banking Rally's Last Gasp

04/23/2009 1:00 pm EST

Focus: ETFS

Michael Shulman

Editor, Short-Side Trader

Michael Shulman, editor of ChangeWave Shorts, says banking stocks have gone about as far as they can in the current rally, and he’s looking for them to sell off again.

The bullishness for bank stocks has ended. The last gasp of the banking rally was the Wells Fargo (NYSE: WFC) pre-announcement that most analysts, me included, thought was aimed at preempting the details in the real earnings report [and] maybe the [upcoming] stress-test results.

The new reality for banks and bank stocks was the Goldman Sachs (NYSE: GS) capital raising and earnings announcement. Earnings were less than met the eye. The dilution to shareholders sent the stock down 12%.

More importantly, the market sold off on this dilution and took no solace in Goldman strengthening its balance sheet and being $5 billion closer to paying back TARP funds.

Why does this matter?

Bank stocks led this rally, and bank stocks will eventually lead the market down as shareholders realize that the solutions to this bank crisis will come out of the hides of shareholders in the form of stock dilution.

The bear-market-rally euphoria was brought on by a very active, self-confident president, and some misleading economic data buoyed by the media wanting to cheer the market on. It was also framed by extreme oversold conditions that will not replicate themselves in the coming months.

Fundamentals, like terrible housing, weakening banks, a weakening economy, tapped-out consumers, and malfunctioning credit markets, will push this market down.

What's really going on is that nothing has changed with [banks’] businesses—nothing! Loan quality is deteriorating, based on spreads, not business activity, operating earnings are rising, the toxic assets are still there, and many assets continue to deteriorate in value.

Banks, and their cousins the insurance companies like AIG (NYSE: AIG), have written off $1.3 trillion in toxic assets. The International Monetary Fund (IMF) says that the total amount will eventually approach $4 trillion in write-offs. 

The next wave of mortgage defaults is now hitting—prime, Alt-A, and option ARM—and analysts Whitney Tilson and Ivy Zelman (the two best analysts based on their work with subprime) think this wave will be bigger than the subprime debacle.

Write-offs of credit card debts [also] rose to a record high in February at 8.82%. Moody's thinks this will reach 10.5% next year and that no bank is reserving enough to cover this amount right now.

Analysts and the rating agencies project a 300% increase in defaults [of commercial mortgages and related debt,] or more than $23 billion more in write-offs to come.

All of this is not built into the stress tests. If, overall, the banks need several trillion dollars more in capital, the shareholders of many institutions will be close to wiped out.

That is why I recommended the UltraShort Financials ProShares (NYSEArca: SKF) with a Buy Under of $70. It's the ETF that goes up approximately 2% for every percentage point down in the Dow Jones Financial Index. (SKF closed below $60 Wednesday. Double-short ETFs are leveraged funds suitable only for risk-tolerant investors who can afford to lose the money they’re investing in them—Editor.)

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