Why (and how) to bet against banks

And the $6 trillion mortgage market is barely functioning as home prices continue to be sucked down, in part because mortgage rates remain stubbornly high despite the Federal Reserve's run of interest-rate cuts.

The futures market for the S&P/Case-Shiller metro-area composite index indicates today's home prices are expected to be 13.8% lower by November 2010. "That's the real problem with financials," says Louis Navellier, the editor of the Blue Chip Growth investment newsletter. "I don't know any way to fix the housing crisis."

(Full disclosure: Navellier's newsletter, and my own, ETF Insider, are published by InvestorPlace Media.)

The risk of shorting

So whereas banks and thrifts were the epicenter of the financial crisis of 1990, today the crisis is dispersed throughout the sector. And though rallies such as last Wednesday's can happen, the general direction is still down.

These days, hedge funds are making fortunes shorting individual banks. Some may even be shorting stocks they haven't borrowed, a maneuver called naked shorting. The SEC is toughening rules to eliminate this tactic, which can have an outsized impact on individual stocks.

But small investors are better off buying securities that go up when the entire group goes down.

Shorting, which is borrowing stock and selling it in the expectation it can be bought back later for less, is impossible for most investors. It requires special clearance at brokerage houses and is forbidden in retirement plans like 401(k)s.

Also, shorting has unlimited risk. If you short a stock at $10 and it goes to $100, you're on the hook for 10 times your original investment. Stocks or funds, on the other hand, can go only to zero. If you put up $10,000, you can't lose more than that.

But there are exchange-traded funds that allow you to effectively short, and even two times short, the financial sector. And even in the worst case, you can lose only the amount you put into them.

ProShares Short Financials (SEF, news, msgs), designed to go in the opposite direction of the Dow Jones U.S. Financials Index ($DJUSFN), was launched only in June, but it had soared 25.6% in the 30 days ending July 15. ProShares UltraShort Financials (SKF, news, msgs), which came out more than a year ago, is designed to move twice as much as the index. If the index falls 10%, it rises 20%. It has ballooned 66.2% in the past month, 104.7% this year and 190.3% in the past 12 months.

One warning: These computer-driven funds are designed to be extremely accurate day by day, but over longer periods they suffer tracking errors as a result of compounding. A 10% loss takes you to 90%, but a gain of 10% on that takes you only to 99%, not back where you started.

For what it is worth, however, this error tends to be more exaggerated when these funds are gaining than when they are falling. That's a double plus for investors; you tend to do better than expected if you're right and suffer less if you're wrong. The iShares Dow Jones U.S. Financial Sector (IYF, news, msgs) is down 23.5% in the past month, 36.6% this year and 48.4% in the past 12 months. These short funds did better than you'd expect based on those numbers.

Before you plunge into this arena, however, be warned that you can still be scalped if the sector rallies.

Between March 10 and May 2, UltraShort Financials plunged 33.7%, and investors in it weren't whole again until June 26. And the mortal who can distinguish a bear market rally from the beginning of a new bull market hasn't yet been born. So be prepared to sell in a hurry or suffer.

But the odds are heavily against financials right now. Technology, the last sector to get bombed out, didn't recover for more than five years.

At the time of publication, Tim Middleton didn't own any fund mentioned in this column.

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