Stay Away from Financial Stocks

I was recently perusing some investing blogs and ran across an article I feel adequately captures my concerns (and belief) that financial mass destruction is probable in 2009. Rakesh Saxena, the article’s author, does a good job explaining the unbelievable amount of financial engineering by the likes of Citigroup (NYSE: C), JP Morgan (NYSE: JPM), Bank of America (NYSE: BAC), Lehman Brothers, Bear Stearns, and many others. Reading this article, as well as the insightful comments, reminded me of two specific reasons why I urge everyone I know to stay away from financial stocks - even shorting them.

What Do Banks Do?

In the aforementioned article, one part I found particularly amusing was Vikram Pandit’s response to a question posed at a Town Hall meeting:

Responding to a rhetorical “What does a bank do?” question at a Town Hall meeting last November, Citigroup (C) CEO Vikram Pandit explained that “a bank takes deposits and puts them to work by investing and making loans.”

Unfortunately, Mr. Pandit, that’s not entirely true. The truth is that large banks in their current form, especially Citigroup, deal in some of the most complex derivatives the financial world has ever seen.

Famed investor Warren Buffett has always maintained that he only invests in businesses he understands very well. I do the same. While I certainly understand a (very small) portion of the large and complex derivatives market, there’s little chance of me explaining it adequately to a novice. In fact, the vast majority of people on this planet probably could not do so, besides (maybe?) the individuals who designed them. Honestly, I doubt Mr. Pandit could even explain them.

So there’s strike 1 against investing in financial stocks; they’re nearly impossible for even Wall Street veterans to understand.

It’s the Government, Stupid

If the free market forces had their way, Citigroup and a large majority of banking institutions would be gone within the year, or at least reduced to a shadow of their former selves. So theoretically, shorting these stocks might be a very good idea. In fact, I believed shorting financial stocks was a great idea back in November, 2007. I was quoted in Business Week here, for my article: Profiting from the Housing Bubble. In the article, I recommended purchasing shares of Ultra Short Financials Proshares (AMEX: SKF) exchange traded fund (ETF), which shorts financial stocks.

Do I still recommend SKF? Theoretically, yes, but practically, probably not. The issue now is summed up quite nicely in a response to Mr. Saxena’s article, courtesy of Crocodillian:

“At this point, though, while all of these firms deserve to go broke, going short is risky– their fortunes now rest in the political arena, not business logic. On what terms will Citi be bailed out? Who can say? It is as much in Washington as on Wall Street that this will be decided.”

Bingo. There are two forces at work here. One is the free market, which dictates that these financial institutions are technically bankrupt (they have insufficient assets to cover their liabilities), and the other is the government, which is keeping them afloat with bailouts. Which one will win? I don’t have the faintest idea.

The Bottom Line

It seems to me that the government will be unable to prevent a wave of financial institution bankruptcies from happening in 2009, which is why I favor shorting over going long. But I’m hesitant to even short; there are just too many unknowns and what ifs.

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.