ETF Talk: Shorting Financials

Financial stocks endured a battering during the credit crisis before a number of them started to recover in recent months. If you’re like me, you’re probably wondering if that trend will continue. You may also be wondering if banks still have an abundance of bad loans on the books.

Third-quarter earnings reports issued in the last week or so by a number of major banks and credit-card issuers indicate that the credit crisis has yet to end. But continued troubles in the banking industry could put money in your pocket if you can time the share-price movements in the banking sector successfully. Of course, market timing is a big challenge for even the best investors, so tread carefully.

One exchange-traded fund (ETF) that you may want to consider for a short-term trade is the ProShares Short Financials (SEF). This fund seeks daily investment results, before fees and expenses, that correspond to the inverse of the daily performance of the Dow Jones U.S. Financials Index. In other words, if the index falls 2%, the fund is designed to climb 2%. That’s good news for those who think that banks still have a long way to go before they fully overcome their problems with bad loans.

The following charts show the index’s top ten holdings and top sectors. As you can see, it is heavily weighted toward bank and financial stocks. 

Much of the data released last week tends to bode poorly for banks, with earnings reports warning about further challenges for lenders. The latest financial results of credit card issuers show rising delinquency rates — a key gauge of future losses — in the face of increased unemployment.

This negative data comes at a particularly bad time of year, as the holiday season approaches. It can be expected that many cash-strapped consumers may increase spending on their credit cards and fall even further behind on their payments.

The troubles for lenders don’t stop there. Issuers of credit cards, including Capital One Financial Corp., J.P. Morgan Chase & Co., Bank of America Corp., Citigroup Inc., Discover Financial Services Inc. and American Express Co., also are coping with sweeping legislation that restricts certain fees and rate hikes. These limits will squeeze their potential income.

In particular, Bank of America Corp. reported Friday that it lost more than $2.2 billion in the third quarter as loan losses keep mounting. That bad news provides further evidence that consumers still are struggling to pay their bills.

Bank of America’s earnings follow the pattern set earlier in the week by Citigroup Inc. and JPMorgan Chase & Co., which also reported more loan losses during the third quarter as consumers strained to keep up with credit card and mortgage payments. Bank of America’s CEO Ken Lewis said, "Based on (the) economic scenario, results in the fourth quarter are expected to continue to be challenging as we close the year."

So, while a recovery may be on its way, it doesn’t seem to be here quite yet, making SEF all the more attractive as a short-term play. 

While I am not recommending this particular fund right now, SEF could offer investors a chance to profit from the ongoing turmoil in the banking industry. However, timing a move into such a fund is dicey. Ideally, you make such a purchase before bad news is announced, then sell the position at a profit once the rest of the investment community becomes aware of the latest problems. If you buy too early or sell too late, such a purchase can backfire on you. If you choose to buy this fund, be sure to monitor your position closely.

For those of you who want advice about which ETFs to buy and sell, check out my ETF Trader service by clicking here. As always, I am happy to answer your questions about ETFs. To send me a question, please click here. You may just see your question covered in a future ETF Talk.