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Friday, March 14, 2008

Bear Stearns situation is bad - will things get worse?

Bear Stearns (BSC) needed a bailout and the Fed accommodated. A big-name financial company was so wounded that JPMorgan Chase (JPM) and the New York Fed had to arrange to provide funding. At first, I thought this is really bad. And it certainly is. By the end of the day, however, I began to think that this signals that we are close to the bottom for financial stocks. There are a number of reasons.

First, though the Bear Stearns situation is a real negative for the markets, it did demonstrate that the government is willing to step in to insure that our most important financial companies survive this downturn. Say what you will about moral hazard and what have you, the bottom line is that the Fed will not let major financial institutions go down the drain. From the point of view of investors in financial stocks, that is a positive.

Second, there have been a number of bloggers and analysts who have pointed out that the bottom won't be reached until institutions that are sitting on excessive amounts of risky assets pay the ultimate price: potential insolvency. We have now seen the first occurrence. Action in the options markets indicates that investors think Lehman Brothers might be the next. Citi is rumored to be getting ready to divest billions of dollars worth of assets to streamline the company and bolster the balance sheet. It looks like we have reached the phase where just deserts will be handed out to those who were reckless.

Third, market trends don't always line up with economic trends. It appears we are in the midst of a recession and a bear market. Financial stocks have led the market down and are significantly underperforming most other sectors. Today's events, however, could be marking a turning point for the sector. Could we see further declines in the financials? It's certainly possible. On the other hand, I get the feeling the duration of further declines may not be so long. Calling a bottom is not an exact science. It may be that we are getting close to the bottom in financials while we may still see further significant deterioration in other sectors. The financials led the market down but they might halt their decline before the economy does.

Fourth, sentiment on the financials is so negative that it is worth stepping back and trying to determine whether it is time rethink the case for further bearishness.

Fifth, as I alluded to earlier in this post, the government is committed to supporting the financial system. They are being creative and proactive lately. The old saying "don't bet against the Fed" may have some truth to it, especially as the Fed seems to be coordinating actions with central banks in other countries. It is clear that they are willing to keep trying different approaches to reducing the severity of the current recession and keeping the banks and brokers afloat. With the FOMC meeting quickly approaching, who knows what they will pull out of their hat next?

As a result of all I have detailed above, I decided that it might be worthwhile to take profits in my position in the ProShares UltraShort Financial ETF (SKF). By the end of the day today we had picked up about a 35% gain since January. If we are close to a bottom, then that is good enough for me. If it looks like we are headed for another leg down in the financial sector, I am sure I will have another buying opportunity for this bearish ETF at some point in the future the next time we have a short-lived bear market rally.

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