The Financials’ Rally Isn’t For Real

07/23/2008 12:00 am EST

Focus: STOCKS

Michael Shulman

Editor, Short-Side Trader

Michael Shulman, editor of ChangeWave Shorts, says there’s more damage ahead for the reeling financial stocks, and he’s shorting some of the biggest names.

Despite [the recent] rally, the situation in banking is bad and getting worse.

The collapse in the share prices of Freddie Mac (NYSE: FRE) and Fannie Mae (NYSE: FNM) and subsequent federal action, as well as impending actions, do nothing to change the fundamentals of the banking sector and will, over the mid- and long-term, hurt the housing sector.

The Fed's actions and the Treasury's proposed actions that require Congressional approval do not in any way protect shareholders from future losses; what they do is shore up confidence in the protection of more than $5 trillion (with a "T") in bonds and insured bonds the two have floating through the world's financial system.

The balance-sheet problems among many banks are not going away. In fact, they could very well be worsening, and reduced stock prices for outfits such as Citigroup (NYSE: C) and Merrill Lynch (NYSE: MER) mean they will have to dilute shares more than ever to raise capital.

Every piece of data available shows that loans of all sorts—small business, construction, credit card, auto, and now prime mortgage—are deteriorating at an accelerating rate. This means the ongoing ability of banks—especially investment banks—to generate profits is now the big question.

How can Merrill and Lehman Brothers Holdings (NYSE: LEH) and even segments of Citi replace profits previously earned through initial public offerings (which are down), private-equity deals (which have all but dried up), securitizing mortgages (never again!) and securitizing corporate debt (dormant) for the foreseeable future? Also, new Federal Reserve regulations will reduce the leverage they can use to generate business and profits for several years, if not longer.

I am standing pat with the fundamental [short] recommendations—these are January puts, after all, which gives us enough time to take advantage of the downside that's still to come and gives us some breathing room in case a short-term rally temporarily props up these guys in the meantime.

We have seen this before—I got a lot of mail from frustrated investors when Citigroup rallied from $22 to $28, when Merrill spiked; when the homebuilders went in the “wrong” direction, and so on.

Hang in there—this was a technical rally due in part to the SEC making a lot of noise about making it harder to short certain stocks. I believe we're in the midst of a massive short-covering rally.

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