RealMoney Silver - The Real Contrarian Trade: Sell Financials

The Real Contrarian Trade: Sell Financials
By Michael Panzner
RealMoney.com Contributor
2/12/2008 2:29 PM EST

By all accounts, beaten-down financial stocks are a contrarian's dream.

The S&P Financial sector is off 30% from its year-ago peak. Each day brings news of multi-billion-dollar writedowns, credit markets in disarray and balance sheets teetering on piles of quicksand capital. The housing market remains in free fall, and a growing consensus believes that a default-ridden, consumer-led recession has already begun.

In other words, there's lots of ugliness around, which can only mean two things: the bad news is in the price and, most likely, there's nobody left to sell. Unfortunately, investors who buy into this particular line of bullishness could be making a serious mistake.

For one thing, more than a few money managers are starting to say publicly that the bottom is in. History suggests, however, that such pronouncements are rarely as bullish as they seem, because genuine turning points tend to appear when everyone least expects them.

Yesterday, for example, Traxis Partners' Barton Biggs said on Bloomberg Television that equity markets were oversold and poised to rally, led by a rebound in banks and other financial shares.

And in a report published Sunday, "Bottom Fishers Nibble at Banks, Brokers," The Wall Street Journal noted that TPG-Axon's Dinakar Singh, Pzena Investment Management's Richard Pzena and Tobias Levkovich, chief U.S. strategist at Citigroup (C) , had turned positive on the group.

But it isn't just the "smart money" that's been buying. So has the "little guy," who's usually not credited with getting in on the ground floor of a tradable rally.

According to Bloomberg,

Investors put $2.8 billion last month into U.S. mutual funds that concentrate investments in financial-services companies, the most since Emerging Portfolio Fund Research started compiling the data in 2004. ... The net new deposits pushed up assets in financial-services mutual and exchange-traded funds by 20% to $17 billion in January.

Other indicators also point to a surfeit of bullishness in a sector that is allegedly out of favor with the investment community.

Jocelynn Drake of The Options Advisor, in a column at Forbes.com, noted that the Schaeffer's put/call open interest ratio for the Select Sector SPDR Financial (XLF) ETF had "drifted lower during the past few months as bullish call options have been opened at a faster pace than bearish put options. As a result, this reading is just 6 percentage points away from an annual low," a potentially bearish setup.

What's more, short-interest ratios for the ETF, as well as for the top 10 constituents of the index upon which the fund is based -- which together account for nearly half of the sector's capitalization -- are at or near 12-month lows. At the very least, that suggests bears have become more cautious as prices have fallen, hardly evidence of excessive pessimism toward the group.

Other bearish signs include the fact that turnover in the sector continues to be heaviest on downticks -- in keeping with the chartist's rule that volume tends to follow price -- and that the financials' weighting in the S&P 500 index is around 18%, still above its historical average of 15.6% since 1990, according to Bespoke Investment Research.

And while the sector has certainly had a decent pullback from last year's highs, the financials remain more than 40% above their October 2002 lows, and are up a whopping 276% since the group began its long-term bull run in December 1994. With that kind of cushion, it's likely there's more downside left before die-hard fans start throwing in the towel, setting the stage for a notable turnaround.

Some fundamental measures also suggest that turning bullish right now could be somewhat premature. In "Beware Value Traps in Financials," ReportOnBusiness.com notes that the typical sector earnings-revisions downgrade cycle last 11 months, according to research by Merrill Lynch, but that financials are "just five months into it."

And as far as the benefits to banks' earnings from the Federal Reserve's recent aggressive easing moves, history may not be the best guide. A Sunday New York Times report, "Cutting to the Quick," argues that many institutions may not be able to fully capitalize on the "carry trade" -- borrowing cheap short-term funds to finance holdings of higher-yielding securities -- because of severe capital constraints.

Finally, one reason the sector has been hit as hard as it has stems from uncertainty over the breadth and depth of the problems the industry faces in future. Following yesterday's shock announcement that AIG (AIG) may have understated losses on certain derivative holdings, it's questionable whether the bad news is known, let alone factored into prices.

In sum, while those who claim to know a bottom when they see it are starting to get worked up by ostensibly negative developments in the sector, the facts suggest now is not the time for bottom-fishing. The real contrarian play, in my view, is to sell (or short) the financials.