Why I Bought the Ultrashort Financial Sector ETF

The recent run-up in the financial sector, triggered by Lehman Brothers' (LEH) capital raising and announcements that UBS (UBS) will be writing off $19 billion, has led to a dramatic decrease in the ProShares UltraShort Financial Sector ETF (SKF). The SKF peaked around $150 in early March as financial companies' stocks were battered by rumors about Bear Stearns (BSC) being insolvent, and then the "come to fruition" moment when investors learned the true extent of their situation. Since then, the SKF has dropped about 33% and now trades around $100.

These circumstances have led me to compile a few questions that I am asking myself in order to understand why the markets think that the Financial sector is ready for an about-face. A few of these issues were recently mentioned on Reggie Middleton's "BoomBust Blog", which I find to be a very good source of independent thinking and analysis.

Reggie writes the following in his articled entitled "Now More Than Ever Requires Patient Investing" related to the extreme volatility we are witnessing in the equity markets, and how extreme volatility can be a signal of a coming drop:

Add in today’s fundamentals (residential/commercial real estate, leveraged loans, monolines, credit crunch, strapped consumer, probably recession, cyclical downturn in banking and real assets, multiple bubbles popping) and where you see the moving average going combined with the aggressive bull run you see we just came off of, and it looks like we should be prepared for a drop…

So, with the following issues (a cyclical downturn in banking, a housing market that still has yet to stabilize, leveraged loan, home equity loan, and credit card debt exposure, credit markets that are still tight, all-time high corporate profit margins, and consumers who are tapped out, not to mention rising energy prices), I am left wondering what those who have driven up market values of companies in the financial sector know that I don't? Or are they not buying on fundamentals at all, and rather HOPING that the worst is behind us?

I for one would prefer to invest my hard earned money on fundamentals rather than on hope. Hope may work well in campaigning for President, but in the financial markets, it is generally not a profitable investment strategy.

Or am I just completely missing something here? All comments are welcomed, and I appreciate challenges to my logic.

Disclosure: Author is long SKF

Comments

[robert99:]

No change necessary - The broad picture has not changed much; the danger of massive bank failure has simply been lessened. You could do much worse than going short on the banks right now.

2008 Apr 04 06:32 AM

[phdinsuntan...:]

just be patient and you will succeed:
March 31
Fiscal Year 2007: Capital/Assets
US
Bear Stearns 3,0%
Morgan Stanley 3,0%
Merril Lynch 3,1%
Lehman 3,3%
Goldman Sachs 4,5%
Citigroup 5,2%
JP Morgan 7,9%
Wells Fargo 8,3%
Bank of America 8,6%
Wachovia 10,2%

2008 Apr 04 06:37 AM

[Alan Brochs...:]

I have the exact opposite bet that you do and am confident that the trade has more to go (probably today). I expect XLF to get to 29 at a minimum but probably 30.5. At 29, SKF will decline from 101 to 83. At 30.5, it goes to approximately 72. I would caution you to consider that stocks move in ADVANCE of fundamentals - that may be why you are correct that the worst isn't behind us but incorrect in your investment strategy.

2008 Apr 04 06:48 AM

[User 5682:]

I haven't yet come to a decision on the financial sector per se. But in general, remeber that stocks anticipate the future and that when crisis dominates the investment case, the time to buy is while the crisis is still present. So whenever the time to buy occurs -- now, next month, six months, next year, whenever -- you can be sure the day-to-day news will still be bad. So your task is not to assess today's news. Instead, determine whether the news is likely to be better a year from now.

2008 Apr 04 07:53 AM

[farfignewton:]

It's possible that all the potential horror is already priced in. The fear of collapse has past. I got into SKF recently just on my total lack of optimism in financials, and the fact that it's at its second 3-month low with the potential for some uptrend after the big bounce, but I don't think we'll see anything close to 150 again.

2008 Apr 04 08:23 AM

[Jeffrey Ber...:]

All of the fears you outlined above and more have resulted in the market downturn we have experienced. You will need new bad news to catalyze a lower low in the markets and financials. I personally had been a believer in a lower low and a more rapid decline in the economy. The Bear Stearns bailout may have forestalled this. The massive money creation by the fed may be propping up the economy. Don't fight the tape. negative moving averages argue for a long period of basing in the market, but a lower low is unlikely without some new heretofore unexpected calamity - 9/11 and the Enron, Worldwom scandals were arguably those type of events in the 2000 - 2003 bear market - hard to bet on.

2008 Apr 04 09:02 AM

[kkin365:]

What are key components (and relative weight) of SKF's portfolio? And how does SKF inversely correlate to XLF? Inferring from one of the posts above, it seems that an increase of 1 point in XLF = a drop of 7.5 points in SKF and vice versa. Have I inferred correctly?

2008 Apr 04 09:44 AM

[User 173177:]

I think perhaps there is a general sense that with the cost of money so low, banks can largely earn their way out of this mess. Certainly the "no bank failures" allowed rule invoked by Bernanke also adds a good measure of misplaced faith. Having being propped up so generously when Financials blow, they really wlll blow.

2008 Apr 04 04:28 PM

[leh:]

I bet the other way as well in one of my accounts on midday Tuesday via UYG and exited the trade with a modest profit Thursday. The follow through in this sector has been weak IMO, but that may have just been big money chasing the very hot steel, coal, and solar stocks this week. Your trade may work fine over time but I would question the entry as many savvy traders are looking for another 5-10% upside here before the downtrend resumes. My own trade was terminated to put the funds to work elsewhere, namely long SGP at 14.76, so far a nice trade.

2008 Apr 04 08:50 PM

[Hope:]

I agree that the stock market on average moves about 6 mths ahead of the economy. The main question then to ask is are we seeing the bottom now or is it still way ahead. With the credit crisis still not resolve, 1st quarter announcements of banks expected not to be any good, Benake is exhausting all his possible tools to pump up the economy, no sign of solution for housing problem, all time high corporate earnings against a low PE.... I'm not too sure how are we getting out of this mess.

2008 Apr 04 11:48 PM

[bearfund:]

I don't have any position in financials right now, which means I missed out on a nice 20% or so gain the past few weeks. I'm comfortable with that because this area is not being driven by fundamentals but by manipulation and politics. If the market were being allowed to sort itself out, I'd probably be long GS and USB and short C, BAC, LEH, and a handful of mortgage companies; they're all as good as bankrupt. But it's not, and among the Fed, their IB and hedge friends manipulating the system with free money, and the wildcard that is U.S. politicians in an election year, I'm staying far, far away from this sector. Long, short, doesn't matter: the risks outweigh any reasonable reward. Remember, the man on the street is paying through the nose for the basics and worried about his job; he's not going to be happy about a $30b bailout for "the fatcats", but when the politicians get going, the fatcats will end up as fat as ever and the ordinary investors will be the ones taking the big losses.

2008 Apr 05 12:41 AM

[silverharp:]

www.howestreet.com/

have a listen to the bob hoye interview, he has been tracking very well, he agrees with the financial short

2008 Apr 05 01:59 AM

[karchad:]

Articles like this are the usual that have made me money in the past. People like this "wait for signs of a bottom" in all sectors, and the market in general. Well, it's been proven a million times: there are no signs. If you wait for signs, you are way too late. That's why investors buy at too high prices.
The best one can do is wait for the market to drop 20%, and BUY. If it drops another 20%, BUY AGAIN. The trick is simple. Buy at low prices. Period. And you know darned well, especially for financial, these are darned low prices. The lowest? Who knows? I don't, you don't, and this writer "don't".
I'm long financials, and long homebuiders. I'm up 19% in 6 months on homebuilders (not annualized, actual 19%). While the experts "wait for signs", I'll make long-term money the only way there is. The rest of you can keep timing the market. I have something stronger: patience.
I think the writer and commenters here are so way off. I've been investing for 40 years like this, and i'm wealthy because of it, without "waiting for signs".

2008 Apr 05 07:31 AM

[Dan Schmeidler:]

Use the financials as a short hedge for your long position. This will work well if you are long anything outside of the financials (such as commodities, industrials, retials, etc.) Build a nice short position on some of the financials while they are still near the top of the recent near 20% run-up. There is little fundamentals that can drive these stocks higher. During the next correction some of these financials should come down again, giving your long position a nice cushion. Then close your short position on the next "dooms-day" or "it's the collapse of all capital markets" kinda days, use the extra cash to add to your diversified long positions, (like buying some of the gold miners at an insane 60 earnings ratio, why not!) and then enjoy another bounce up. The banking industry in general is going through a drastic change this time around. A change towards socialization due to their inability to be profitable without goverment intervention. This means less prospects for profitability and real growth. In fact, it appears that our government acutally enjoys watching these monsters bleed to death slowly. In the future we are going to see less branches and far longer waiting times and longer lines. Kinda like banking in Moscow in the 1960's, or East Berlin in the 1970's. Wait, do the communists even have such a thing as banking? Wealth management and private banking will also change to some degree. This bail-out will come at a cost, and the government is not going to let this industry off the hook until they get on their knees and answer to "who is your daddy". Good luck with your trading.

2008 Apr 05 02:10 PM

[jstratt:]

I have also been investing in the financials through the XLF and in GS. I think the things mentioned in this article have been factored into the up to 40% drop in financials.

Looking forward I see reduced risk (but clearly still risks) and greater reward opportunity. I am adding back to financials on pullbacks.

It is at times like this I am reminded of the words of a past mentor who said "You cant lose something you never had" meaning dont get greedy. Just move toward your longer term target allocation.

2008 Apr 06 11:07 AM

[skibum:]

I also trade SKF and UYG, and recently have positions in both as a base for covered call selling. The volatilty yields some pretty good premiums. I doubt SKF will reach old highs unless we have a "new bombshell". Repeating "old problems" never drive the same level of fear.

2008 Apr 06 12:17 PM

[Jim Hawthorne:]

The 50-day MA of the Financials (XLF) is still in a distinct downtrend, and the stochs, TRIX, RSI, and MACD appear to be calling for another move to the downside...
I think you'll be satisfied with your trade if you take profits at the first sign of weakness in SKF, or before the Hank and Ben swing into action for yet another rescue mission.
Make no mistake; the current mess in the financial sector will take years, not months, to heal.
Yes, I went long SKF, SRS and am also short LEH and JPM.

2008 Apr 06 05:45 PM

[DJS:]

I'm also long the SKF (ultra-short financials) at the present time. I fell pretty confident about this trade for the next 2-3 months or so.

In my opinion, the move by the financials last week is not sustainable. That move was just long-only mutual fund money buying in at the beginning of the new quarter (after selling into the quarter end to avoid showing these positions in financials to shareholders at quarter end). Remember, many mutual funds have to buy financials to ensure that there performance does not deviate too much from the S&P 500 index benchmark for performance (which is overweight financials). Nothing else but strong mutual fund buying sends large cap financials up 3-5% in a week in which UBS and Lehman are desperately raising emergency capital.

In my opinion, the recent uptrend will be a short-lived phenomenon. Earnings will be terrible this quarter with more write-downs to come.

Furthermore, there is no catalyst to send the shares of large cap banks and i-banks higher. M&A fees are down with reduced PE activity. Corporate finance underwriting is doing okay after the big Visa IPO, but it's not great. Existing leveraged loans on banks' books cannot be securitized and sold. SIV's assets cannot be kept off-balance sheet, which inhibits growth. Tier 3 assets are becoming worth less and less. Capital ratios are shrinking. Fixed income trading revenues are down. Mortgage-backed and asset backed securities businesses are closing. Equities trading is a commodity-like business that loses money. The only way i-banks like Goldman. Merrill and Lehman are able to make serious money right now is through merchant banking and putting their own capital to work in risky equity and fixed income trades. Sure, i-banks are very, very good at making money by engaging in such activities, but to do so they are taking enormous risks and acting just like giant hedge funds. Otherwise, only the high end asset management businesses are growing slowly and steadily (but retail brokerage is not).

So overall the trend for large cap banks and i-banks is still lower. I can think of no catalyst that would make me buy them. Where is the new growth business that will replace the lost earnings from their dying PE-driven M&A and mortgage securitization businesses? Nothing would make me get long financials here - nothing. Not lower interest rates and not the Fed taking mortgage backed securities from i-banks as collateral for loans. Nothing.

On the other hand, I can think of one huge catalyst that will send all these banks lower. COUNTERPARTY RISK ON OUTSTANDING CREDIT DEFAULT SWAPS (CDS) WITH A NOTIONAL VALUE OF $30 TRILLION. What happens when the corporate bond default rate ticks up to 5-7% in this recession and these banks learn that some of the hedges they put on in the CDS market are not effective because their counterparty to the CDS trade is a bankrupt bond insurer or a defunct hedge fund or another capital impaired i-bank?

If you listened to Tim Geitner speaking to Congress last week during the Bear Stearns hearings, then you heard him discuss how concerned the Fed is about the risk of cascading or systemic failure in the giant CDS market. Geitner indicated that this was the only reason why the Fed stepped in to help JPM save Bear Stearns. And, in fact, many have speculated it's the only reason JPM saved Bear -- i.e., because JPM did not want the CDS market in chaos. Will such a systemic event happen in the CDS market? I have no idea. But the risk is out there as a very negative potential catalyst and the people who know, know that CDS counterparty risk is what everyone should be very afraid of. And it is not priced in.

2008 Apr 07 12:01 PM

[FIG trader_:]

The presumption that the factors you mentioned (UBS and LEG capital raising) are responsible for the decline in the SKF (rise in UYG) is just that. And to suggest this about face (in financial stock performance) is unwarranted, while not addressing more specifically the reasons for why 1990 level price/book valuations for much of the financials is the appropriate price level puts you in the same category with the rest of the crowd, and not contrarian as your bio suggests. This group of stocks is still way out of favor. Many posters mentioned the market anticipate the news, which in fact it does. There is almost a 100% chance that the SKF will be higher at some point in the next few months and a 100% chance that it will also be lower at a different time. Depends on your time frame. But if you are a "investor" as opposed to trader than you need to mathematically find what the market is discounting in terms of ROE's and valuation (expansion, contraction) through 20010. Only then is it worth discussing. Otherwise take out a chart and use the right technical methodology for looking for entry and exit points over the short term. It works better for that time frame

2008 Apr 09 12:32 PM

[ddtuttle:]

Look at Mr Mortgages newish web-site mrmortgage.typepad.com.../
originally recommended in Herb Greenberg's blog. There are at least two more trauches of mortgages poised to melt-down: alt-A and the "option pay" (which have some over lap).
These are bigger than sub-prime. The recession will make all these worse with job losses, commercial real estate, and bond defaults.

In march California had 3.5 times the number of defaults as purchases in residential real estate ... (whoa)

We will have 100's of billions more mortgage write downs over the next few years. The real problem is implicit in the fed's bail out of Bear: if Bear had failed, the web of counter-party derrivative obligations would have brought the whole system down. That scenario is still very much on the table. If we back out of that slowly, it still mean enormous changes in captial ratios for all these banks. That is, they need alot more cash on hand, which means less loans, more recession, lower housing prices etc.

An already stressed financial sector will not respond well to any of this.

DDT

2008 Apr 18 05:24 PM