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We have identified 5 financial sector stocks that investors can consider shorting when constructing their portfolio. The stocks include banks from the United States and Canada, along with a couple of REITs from the U.S. The remaining article discusses each stock in detail, with reasons as to why we are recommending short positions in them.

Goldman Sachs Group (GS)

Goldman Sachs provides a variety of financial products to its clients across 30 countries, and operates in investment banking, institutional banking, investing & lending, investment management and institutional client services.

The bank posted a rather disappointing set of results for the first quarter this year. Both the top and bottom lines plunged by 16% and 23%, compared to 1Q2011. None of the four business segments witnessed any increase in either revenues or earnings, which led to overall depressed earnings.

The bank's stock is trading at a moderate premium to its price-to-book multiple of 0.68x, compared to its industry peers. Investors are concerned whether Goldman Sachs could earn enough to cover its cost of capital. The company offers a return on asset of 0.41%, as compared to 0.63% offered by its peers. Its return on equity has not shown any improvement from 1Q2011. The stock is up 5.2% since the beginning of the year, however, it has lost 30% of its value over the last one year.

Though the rating cut by Moody's for the bank was in line with expectations, however, going forward, the bank is expected to face a rise in borrowing costs. The bank is viewed to have always worked for the benefit of its employees, even at the expense of its shareholders. The ever-larger compensation packages for its executives support the view. It had the most talented workforce in the entire industry. However, more recently, the bank has been accused by its own executives to have sidelined client interests, and have accused the bank of having lost its moral fiber. These accusations could have serious consequences for Goldman Sachs, who is losing the confidence of both investors and employees. The continuing threat of legal liabilities and a slowdown in capital markets will have an additional negative impact on the bank's earnings. A continuous low interest rate environment, along with talks to further easing by the Fed, will negatively impact the bank's investment banking revenues, commissions and fees. The bank's investment management revenues will be hit if asset prices decline further, or investors tilt their mix of assets towards low risk assets.

In conclusion, based on our above analysis, we believe that Goldman Sachs will have to face a difficult time ahead, due to an operating environment marked by continued macro uncertainty and other bank specific reasons that have been mentioned above. We recommend investors build a portfolio short Goldman Sachs's stock.

Canadian Banks

Canadian banks, with large exposure to the Canadian housing market, present a perfect opportunity to be included in a portfolio of short stocks. Royal Bank of Canada and Canadian Imperial Bank of Commerce are two such banks that will experience difficulties once the Canadian housing bubble bursts.

Royal Bank of Canada (RY)

A majority of the chunk (about 69%) of all the revenues that the Royal Bank of Canada generates, accrue from Canada, while the rest comes from the U.S. and other international regions. The bank has enormous amounts of residential mortgage sitting on its balance sheet. More than half (approximately 54%) of the bank's balance sheet is composed up of a single asset: residential mortgage. Only 39% of the total residential mortgages that the bank owns are insured by any Canadian government agency or a third party. This leaves a majority of the portfolio exposed to default risk. During the second quarter of the current year, the bank was able to earn an interest spread of 2.72%, which is 100bps below what it earned during the first quarter this year. With the recent more stringent regulation on mortgage originations, the anticipated Canadian housing bubble burst and the resulting mortgage rate wars among Canadian banks, to target fewer eligible clients for business, the bank is expected to earn a narrower interest rate spread. The bank's income is tilted towards non-interest income, with 60% of all revenues coming from it. This income will be hit due to lower expected mortgage origination activity in the event of a slowdown in the Canadian housing markets. Since only 39% of its mortgage loans are insured, the bank is likely to face substantial default risk if homeowners fail to pay. The bank is trading at premium valuations. The bank's stock trades at a 9% premium with regards to its price-to-tangible book value of 2.4x, compared to its industry peers. Share prices have plunged by about 9% over the past one year.

In conclusion, the Royal Bank of Canada is overvalued, and has substantial exposure to residential mortgages. Therefore, its income from interest and non-interest income will be affected in the event of a Canadian housing slowdown. We recommend a short position in the stock.

Canadian Imperial Bank of Commerce (CM)

Like the Royal Bank of Canada, a majority of the balance sheet of the Canadian Imperial Bank of Commerce is composed of residential mortgages. They are 40% of all the assets that the bank owns. 22% of the residential mortgages are neither insured by any Canadian government agency nor any third party. Its revenues have a tilt towards interest income and earn 57% of revenues from it. During the second quarter of this year, the bank earned an interest spread of 1.82%, which deteriorated from 1.85% in the first quarter 2012 and is 90bps below what the Royal Bank of Canada earned during the same period. The spread that is already below its competitors is poised to take a hit if it is forced to narrow its spread in order to compete for new mortgage clients. Even though a larger proportion of the bank's residential mortgage holdings are insured by a Canadian government agency, it will experience a decline in earnings due to a decline in mortgage originations due to more stringent rules introduced by the Canadian government.

The stock, with a price to tangible book value multiple of 2.12x, is trading in line with its industry peers. Consistent with our views, Fitch is also concerned about the Royal Bank of Canada's and Canadian Imperial Bank of Commerce's enormous exposures to Canadian real estate. This is why the stock has lost 10% of its value over the last year.

The bank is organized for reporting purposes into retail and business banking, wealth management and wholesale banking. Driven by a slow demand in mortgage originations in the event of a much anticipated slowdown in the Canadian housing markets, the bank's retail and business banking segment revenues will face a decline.

In conclusion, even though most of the residential mortgage portfolio of the bank is insured, the bank will still find it difficult to earn a wider interest spread and income from mortgage originations. The will create challenges for the bank in the coming quarters. Therefore, we recommend that it be part of our short portfolio.

REITs

iStar Financial Inc. (SFI)

iStar Financial, a diversified REIT in the U.S. financial sectors, focuses on commercial real estate (office, industrial, entertainment, hotel, and retail facilities), providing customer solutions to high net worth private and corporate owners of real estate. The New York-based company's primary financial products include senior and mezzanine real estate debt, senior and mezzanine corporate capital, corporate net lease financing, and equity.

The reason why we are including this diversified REIT in our short portfolio is that the company has been in losses since 2008. Besides this, the company had negative cash from operations. Since the company is under losses for some time and its cash flows are negative, it is not in a position to even service its debt payments, let alone sustainable cash distributions to shareholders. This is why the stock has lost approximately 20% of its value in the past one year. However, the stock is up 27% since the beginning of the year, which represents a good entry point. 22% of the free float is already shorted by investors with a high short ratio of 19.4. The company last paid a dividend of $0.87 in July 2008.

DuPont Fabros Technology, Inc. (DFT)

DuPont Fabros Technology, with a market cap of $1.78b, operates in the Property Management Industry of the U.S. financial sector. The company seeks to acquire, maintain and lease large scale data center facilities. The Washington-based company elected to be taxed as a REIT.

The company has experienced significant declining growth in its quarterly earnings. The stock is trading at a significant price-to-earnings premium of over 100% when compared to industry peers. Though the stock has a short ratio of 16.7, while 28.7% of its free float is shorted by investors; however, shares are approaching the 52-week highs, and are up 16.5% on a YTD basis, which represents an ideal entry point for short selling.

Source: Qineqt Presents Its Financial Sector Short Portfolio