Financials Not Promising In Light of Potential Rate Cut

With possibly the most anticipated Federal Open Market Committee meeting in months about to happen, active investors must know how to correctly play the markets up to and after the Fed meeting on September 18th. What we must know about the current markets is that a Federal Funds rate cut has already been partially priced in. Ever since the markets began to turn around when the Fed cut the Discount rate by 50 basis points, many stocks traded on much higher valuations due to the perceived "loosening bias" of Chairman Bernanke. Because of this, the major indexes have recuperated approximately half of their losses in the past 2 weeks. However, is a 25 basis point rate cut in the Federal Funds rate as certain as many feel and what insight will the Fed's decision provide into the coming months?

The answer is nowhere as clear as anyone claims to say. A rate cut is not impossible, but is not a certainty. Recent economic data showed that GDP grew at a rate of 4% in the last quarter and inflation rose at a moderate pace. While weekly jobless claims hinted that the recent sub-prime mess was having a negative effect on the macroeconomic picture, there are no obvious signs that we are headed towards a recession. On the other hand, Bernanke cannot decide to cut rates only once our economy is neck-deep in a recession. A rate cut would give an initial boost to the indexes, however hint at a slowdown. On the contrary, no rate cut would disappoint markets initially, but hint that the Fed does not believe a recession is imminent.

Because the market has priced in a rate cut, investors can take advantage of this situation. It is important to find companies and sector ETF's that have rebounded off of their lows because of this rate cut speculation. Financial services companies were severely battered by the sub-prime concerns and have recently rebounded significantly. Both banks and brokerage houses have come off their lows, the SPDR's (XLF) and iShares (IYF) both recuperating almost half of their losses. Financials is the sector "banking" most on a rate cut, and consequently would be hurt the most by a continuation of the 5.25% rate. Despite recent downgrades, many of these companies have risen from their single-digit multiples because of "certainty" amongst investors that Bernanke will save these corporations by a rate cut.

One good way to play this situation is to short financials and any ETF's that represent them such as the XLF or IYF. If Bernanke does not provide a rate cut, then shorting the financial ETF's and companies will be advantageous only in the short term since a rebound would have been confirmed. If Bernanke does cut rates, then shorting the financials will be a successful long term strategy. With increasing sentiment amongst economists that the sub-prime issue will lead to a widespread recession, I believe the latter strategy has better chances of success. In addition to shorting the 2 major financial ETF's, investors can short individual corporations that will be hit exceptionally hard when their Q3 balance sheets come out. Lehman Brothers (LEH), Bear Stearns (BSC) and Goldman Sachs (GS) for example will be hit harder than traditional banks such as Citigroup (C) and J.P. Morgan Chase (JPM). Bloomberg news recently speculated that Q3 profits for investment banks will fall 76%, more than twice what they fell in the 1998 crisis.

Regardless of the rate cut decision, the coming 3 months or so will continue to provide instability and volatility in the stock market. At current valuations for financial companies, there is little upside for their share prices unless miraculous profits are reported. As investment banks announce their Q3 profits due to the sub-prime mess, a short on financials will undoubtedly prove to be a successful investment.

While we may not get a rate-cut in September, the chance that Bernanke cuts rates soon is very likely. Many economists believe that soon macroeconomic indicators will start showing the true toll that the sub-prime situation is taking. Once this comes and Bernanke sees these factors, then there is a chance that he may reduce the Federal Funds rate by 50-200 basis points. Comparing the upside to the downside on financials, a short on the companies and the ETF's will have a similar risk and reward to a financials options put contract.

Comments

[Victor Zhu:]

right now the fed rate is at 1%. The Federal is out of plan. THe only way to tackle this problem is to cut down the mortage rate and decrease the inventory of housing.

2008 Dec 08 10:51 PM