Why (and how) to bet against banks

By Tim Middleton

Almost without anyone noticing, last Wednesday financial stocks had their biggest one-day rally ever, with the financials in the S&P 500 Index ($INX) soaring 12.3%.

With that, the group regained its status as the third-largest segment in the index, having slipped to No. 4 behind health care just the previous day. But it wasn't too long ago that financials were the index's largest sector, and despite last week's action, their prospects remain miserable.

"We've seen unprecedented carnage in this sector, and there are no signs it is over," says Alec Young, an S&P equity strategist. "We would urge investors not to be too tempted in this area."

I confess I have been tempted, arguing that because financials took the economy down, it will be up to them to lead it back. In February, my fundamentally bullish column on the group was headlined "Financial stocks: The stars of 2008?"

The answer to that question so far: No. Events have been giving my optimism quite a thrashing.

So today I'm going to suggest what I believe will be the smartest way to play this group for at least the next six to 12 months. That would be to short it, betting these stocks will fall even more.

Shorting made easier

Shorting is something many everyday investors have never done, but it's increasingly easy thanks to inverse and leveraged-inverse exchange-traded funds.

Next week I'll take another look at the group from a different perspective, that of so-called value funds. Chances are you own at least one big brand-name fund that wears the value label. Supposedly this style of investing delivers the best long-term results. But value is married to financials, and that means this beaten-up shoe has a big hole in its sole.

Why? Because the gap in financials is a black hole, feeding on the despair it creates. That's also what makes the financial sector perfect for shorting.

Yes, these stocks have already fallen quite a distance. If you get in too late and you're short, a serious move up can hurt you. But we've heard several times already that the worst was over, and it wasn't.

Deepest damage ever

Financial-sector funds are the worst-performing equities in the world now and by a wide margin. They're down an average of 24.6% this year, even after last Wednesday's rally. Large-capitalization growth funds, which are only lightly invested in financials, have fallen only half as much.

Banks and their brethren have endured epic bear markets in the past, most recently in 1990 at the depth of the savings-and-loan crisis. But this time, at least in the market's mind, is different.

Back then, the magnitude of the financial calamity could be grasped and was measured in billions of dollars. Even when it burgeoned from losses estimated at $50 billion to four times that amount, the extent of the damage could at least be understood.

Sweeping debt woes

Today's financial meltdown defies comprehension because so much of it is packaged into exotic derivatives, such as collateralized debt obligations and structured investment vehicles. These were bundles of risky loans such as subprime mortgages put together and sold by institutions eager to spread risk and keep lending.

Now, they embrace possibly $2 trillion or $3 trillion dollars of indebtedness spread far beyond banks and savings and loans to insurance companies, pension funds and the like around the world.

The marketplace for these exotic bundles has seized up. Meanwhile, other asset-backed securities are plunging because defaults are rising amid the sickened economy. More and more homeowners and consumers simply can't repay their loans.

Continued: Mortgage crisis

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