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The schizophrenic market participants (as opposed to the market) have shown moods that swing from total despondency to semi-euphoria over the last several months, especially in the financial sector. For us, it indicates what we have long believed: few investors have any real convictions about how to value financials and therefore react to the news (or noise) in a herd fashion.

While we firmly believe it is possible (and absolutely necessary) to trade when given the opportunity, one shouldn’t confuse that with investing based on traditional principals.

This is one of those moments where investing is becoming more difficult and trading somewhat easier, following the rate cut rally. It is more difficult to invest (or make the case to not invest), because two variables that have entered the equation loom rather large on assessing the quality and sustainability of earnings: interest rates and the dollar.

The emphasis on US broader market gains without closer scrutiny of the longer-term implications of a virtual collapse in the currency seems short-sighted. We would add that the rather punk rally in large capitalization financial names and continued backing up of Treasury and corporate yields, suggests serious concerns about the ability of most of the global banks to make money in credit.

Shorting some of the small and mid capitalization names (FMT $5.28, FMD $38.44, BER $29.17, PHLY $38.20) as well as higher beta names that have rebounded (GS $205.95, AIG $66.97, AXA $42.89, ACE $59.70, XL $76.42) and are up against significant resistance seems the optimal trade as of today.

It’s virtually hopeless to try to measure with any precision the impact on future earnings from the change in the credit conditions. If estimating broker/dealer earnings was hard before the “crisis”, it is not likely to get any easier today. What has changed is the cost of being wrong; today, the cost of being wrong (for longs) has diminished given where we stand relative to the earlier year highs. And one shouldn’t give too much credence to the “theories” or “patterns” (related to Fed Rate cuts) suggesting the financial stocks will be much higher 3 to 6 quarters after the first cut.

Source: Opportunistic Short Opportunities In Financials