A Contrarian Play on Financials to Consider Just in Case

Apr.30.09 | About: ProShares UltraShort (SKF)

I have a faithful friend who is always there in my back pocket and watching my back with the markets. His name is Justin Case (as in "just in case…"). This time I have consulted my contrarian friend about the prospects for a "sell in May and go away" trade. While sharing a few glasses of Shiraz, we had the following conversation:

Me: Justin what do you have on your radar these days?

Justin: Well, everyone knows or should know that the results from the stress tests for the 19 largest banks will be released on May 4, 2009.

Me: Yes, I’m quite aware. In fact, for my readers’ convenience and reference, I have created a list and sorted it by industry groups since it appears to be a financial basket of apples, oranges, pears, and etc. Here it is right here if you want to take a look…
Bank of America (NYSE:BAC)
Bank of New York Mellon Corp (NYSE:BK)
Capital One Financial (NYSE:COF)
Citigroup (NYSE:C)
JPMorgan Chase and Co. (NYSE:JPM)
Keycorp (NYSE:KEY)
Pnc Financial Services Group (NYSE:PNC)
Regions Financial Corp (NYSE:RF)
Suntrust Banks Inc (NYSE:STI)
State Street Corp (NYSE:STT)
US Bancorp (NYSE:USB)
Wells Fargo (NYSE:WFC)
Financial Services
American Express (NYSE:AXP)
Fifth Third Bancorp (NASDAQ:FITB)
Goldman Sachs (NYSE:GS)
Morgan Stanley (NYSE:MS)
Metlife Inc. (NYSE:MET)

Justin: Not bad….

Me: So you like the wine?

Justin: Clinton, the wine is fine, but I’m talking about the list. You might want to include the following link (The Supervisory Capital Assessment Program: Design and Implementation - pdf file) for anyone interested in the details. It’s a 21 page report issued by the government on April 24, 2009.

Me: Thanks. So answer my question. What are you thinking about or what do you see? Have the bears quietly sneaked off into hibernation or what?

Justin: Well, the bears are still out there on the prowl. Some of them had to cover as they got too greedy dipping into the honey and got stung by a swarm of bulls. But bears are cagey sneaky bastards, so watch out.

Me: Hey Justin, just get to the point, eh?

Justin: Oh yeah, right… Well I’m thinking that many believe this whole cesspool of write-offs has been contained. Yet the Fed speaks with a forked tongue by saying that most banks are well capitalized, and then at the same time issues a statement that some banks may need more capital. Let’s pretend the Fed is correct due to playing some sort of semantics game unbeknown to most of us. Maybe these banks don’t need capital from the Fed but still need to raise capital on their own. Besides, judging from the populist reactions, giving these banks more taxpayer money would be tantamount to calling forth the guillotine and the American version of the French revolution. If banks raise capital on their own, e.g. preferred shares, it would be dilutive to their existing shareholders.

Me: And what about the regional banks?

Justin: There’s all this talk about the 19 largest banks. This is a classic ruse of misdirection with focus being shifted to big banks. However, the FDIC’s list of troubled banks has jumped from 1568 banks with $2.3 trillion in assets to 1816 banks with $4.4 trillion in assets over a 3 month period. Please… Besides that, no one has yet to really address all the bad construction and development loans waiting to float to the top of the cesspool.

Me: Alright, I get the picture, but what should I be looking at to make money if the market starts to become concerned with your concerns? Otherwise, all this is useless pontification.

Justin: I was going to get to that, but you interrupted me. Pass the wine, Maynard. Take a look at the ProShares Ultra Short Financials ETF (NYSEARCA:SKF) and consider buying a bull call spread. Go long the June 50 calls and short the June 55 calls for a net debit at $2.10. Your maximum potential profit is about 238%. The SKF is currently trading at 56.12 and has been oversold forever and a day since the March 2009 rally. Your break even point is at 52.10 or -7.16% downside from its existing price. The percentage allocation from your aggregate portfolio should be determined by the amount of capital you are willing to risk on this trade, okay?

Me: I’ll give it some serious consideration. After all, the XLF is up a whopping 76% from its March 6th lows and I’m not so confident that things have improved significantly enough to justify additional upside once shorts have covered. Cheers to friends, eh?

(p.s. Inspired by Wednesday afternoon’s phone conversation with Hillbent and Seeking Alpha contributor, Brent McCosker, my longtime friend who resides in Quebec, Canada and with whom I will reunite in Santa Barbara, CA @ mid-May 2009. Looking forward to it…)

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