Expecting a Short Squeeze in Financials

With the financial sector now in the “selling climax” phase, the pain trade seems likely to reverse itself with a vengeance in short order, with a short covering rally of significant proportions likely to unfold within the week, if not the next twenty-four hours.

As such, short financial positions should be closed, and, for those with a short time horizon, long trades in what have been “suspect” names, such as ABK $23.00, MBI $33; CFC $14.5, MTG $18, WM $23.0, ACF, $13, COF $59.0 should be put to work with what we see as potential 15% to 25% upside in a matter of weeks.

A month or so since the last post here, and the performance of our short recommendations made at that time is decidedly positive, but albeit still a bit disappointing versus our expectations (see below). The liquidity event pulverizing the highly leveraged players in the financial sector is combining with a broader (not exclusively sub-prime) credit event. Absent any major company specific nuclear bombshell (i.e. potential bankruptcy clues in the 11/15 -10 Q filings next week), it appears that the market will continue to take its cues from the CDS market: those with banker ties and with their ears closest to the deal-making and capital raising. From our perch, in this cycle, we think we are probably close to two thirds of the way down in terms of total dollar price declines (relative losses including currency would be substantially more) for the sector, and maybe only half way in terms of duration. In other words, buyers will likely still suffer through lower lows at some point in this cycle (i.e. 2008).

But the severity of the declines in regional banks (specifically California, Florida, and Midwest banks, and expectations priced into the stocks (i.e. 4% to 7% dividend yields suggest there is considerable pessimism (sometimes warranted sometimes not) already priced in. We sense that there will be more opportune entry points for shorting again next year post short-covering rally and as we approach the final credit blow-off in 2008/2009 in the prime market.

Performance from previous post in late September: A few short positions carrying small losses (Losses were in the low single digits for GS, $216, PHLY, $39.0 and BER $29, respectively) with gains of 60%-plus, 5%, and 10%-plus for FMT, $2.00, AIG, $59, and XL $63., respectively. All positions closed today.

Fundamentally, the fourth quarter will likely be a “kitchen sink”, though trough normalized earnings will probably be a 2008 event.

Just in case you asked, you can still stay short First Marblehead (FMD $35.10) and not lose much sleep.