Michael Shulman

The Best Way to Trade the Banks in Early 2009

by Michael Shulman   12/24/08

Here's an example: Citigroup (C) has more than $1.2 trillion in off-balance sheet assets of unknown quality -- that's trillion with a "T." They are held on Enron-like entities called "qualified special-purpose entities" (QSPEs) and "variable interest entities" (VIEs).

Morgan Stanley (MS) has to deal with the option ARMs it got when it bought Washington Mutual. Wells Fargo (WFC) must do the same with Wachovia's option ARMs. And Bank of America (BAC) has to digest Countrywide and Merrill Lynch's (MER) dodgy assets.

These are the big names, and core banks like these make up more than 40% of the Dow Jones Financial Index. General financial stocks make up 23%, and their businesses are cratering. Real Estate Investment Trusts (REITs) having trouble collecting rents comprise 13% of the index. Insurance companies writing off assets every day and getting 2% on their T-bills are 20% of the index.

So, the Dow Jones Financial Index is in deep yogurt as earnings and losses come in over the course of 2009. And as the index falls due to weakening fundamentals, the SKF will rise.

How to Play the Banks

The fundamentals tell me the banks are going to take a big hit, but when?

Let's go back to the put and call premiums. Many in the market are betting that the banks will have horrific earnings -- the big ones report in mid-January -- and their stocks will fall. Many also think this is already built in.

So I want you to forget about January and look further out -- perhaps as far out as April -- when you play the fundamentals.

I am not suggesting that you buy a call on a double inverse ETF. Yes, it is the ultimate rocket-fueled short trade, but the SKF is very volatile, making calls a very high-risk play.

I picked the SKF to illustrate current sentiment. That said, based on fundamentals, there could be some very rewarding opportunities in bank puts after January. So, I suggest you take a look.

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Michael Shulman is the editor of ChangeWave Shorts. To learn more about him, read his bio here.

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