Morgan Stanley: Sell the Rally in Financials

Morgan Stanley (NYSE: MS) advised clients on Monday to sell into the rally in financial stocks. Morgan analysts Betsy Graseck, Cheryl Pate and Justin Kwong anticipate further dividend cuts, increased dilutive equity offerings and the continued deterioration in the credit markets.

The comment which was perhaps the most revealing of all, Morgan analysts suggested that we are only in the “3rd inning” of difficulties in the credit markets. This makes Morgan Stanley one of the first - and one of the only - banking institutions that has come out with an extremely negative outlook on the financial markets. The vast majority of financial institutions have recently declared that “the worst is over;” leading to a rally in financial stocks. Indeed, financials in the S&P 500 are trading up more than 15% from the March 17th fall of Bear Stearns.

Have conditions really improved that dramatically since that fateful Monday? That’s a simple sounding question with a complex set of answers. The credit markets have improved, in terms of increased liquidity, with the Fed opening up the discount window for investment banks. However, the real economy, which has had only a minimal impact on the financial markets thus far, is deteriorating rapidly. Home prices are continuing to decline, costs of living are continuing to increase (look at the price of oil and food for examples), and the job market is reeling. The real economy will come back around and hit the financial institutions far harder than the freeze in the credit markets did. The Fed put out one fire, but threw gasoline on the other - through massive inflation - and we have not even begun to witness the effects this will have on our economy.

I am encouraged by Morgan Stanley seeing through the false rally. Their belief that we are in the 3rd inning is probably very close to the truth. We have seen roughly 8 months of deterioration, making the 9th inning scheduled to start in late 2009. I think that might be a bit optimistic, but far more in-line with reality than the “experts” who control the financial media would have you believe.

If you subscribe to the belief that we are in the 3rd inning, then you might want to consider purchasing shares in SKF, an inverse exchange traded fund that goes up 2% for every 1% financial stocks go down. Check out an earlier investing blog post that discusses SKF in more detail, as well as the housing and credit crises.

Freund Investing Managing Member Ryan Freund holds no position in any of the companies mentioned in this article. Freund Investing has a solid Disclosure Policy.