The recent rally in the financial sector raises the issue of whether it's time to reestablish short positions in the group in order to take advantage of an extremely overbought situation and the inevitable profit taking that is sure to come.
The S&P 500 financial sector is now trading 28.5% above its 50-day moving average, which is the highest level recorded since 1990. This is reflected in the performance of the Financial Select Sector SPDR (NYSE:XLF), which is up 90% from its 52-week low.

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While it wouldn't be against the laws of physics for the sector to go higher, it's probably safe to predict an upcoming pullback. It would be logical to short the banks that have moved up the most due to short covering and a change in sentiment, rather than in response to fundamentals.

Big American Recoveries
Regions Financial (NYSE:RF) has nearly doubled off the low it reached in March 2009. This recovery was led by the bank's surprise announcement that it would report a profit in the first quarter. Investors should probably be wary about the quality of this report, as both Goldman Sachs (NYSE:GS) and Citigroup (NYSE:C) boosted earnings through accounting maneuvers rather than core profits. Goldman Sachs changed its fiscal year, which had the incidental effect of excluding the month of December from its earnings, while Citigroup booked a $2.5 billion gain from marking down its liabilities.

Real Estate Fears
Fifth Third Bancorp (Nasdaq:FITB) also had a huge move, more than tripling off the bottom recorded in March 2009. Yet Moody's just downgraded the company to Baa1, and Fifth Third has exposure to weak real estate markets in Michigan and Florida. During the bank's fourth-quarter conference call, it said that "37% of our commercial real estate non performing assets" were from these two areas.

Surging British Banks
The British banks may also be a place to lay down some short bets. At the beginning of the year, investors had written off the banking system here as all but insolvent, but now both Lloyds Banking Group plc (NYSE:LYG) and Barclays plc (NYSE:BCS) have surged off their lows.

The British government now has majority control of Lloyds and the bank participates in an asset protection plan sponsored by the government. Although this may have strengthened the bank in the eyes of the market, one could argue that with the government firmly in control, and the experience of the American government meddling in our banking system via the Trouble Asset Relief Plan (TARP), there's no telling what the British government will do next.

Barclays is in better shape and declined to participate in the asset protection plan, and is instead selling assets to boost capital. The bank may suffer, however, if a downward trend reasserts itself in the financial sector.

The Bottom Line
The recent overall market rally, and financials in particular, has reinvigorated the dwindling community of bulls on Wall Street. However, this sector has moved ahead of fundamentals, and may be headed for a pullback. Evidence of this can be seen from Bank of America (NYSE:BAC), which reported in its latest earnings report that "credit quality deteriorated further across all lines of business as housing prices continued to fall and the economic environment weakened." The bank now has a provision for credit losses of $13.4 billion. The bottom line is that investors who play the short side may want to reestablish positions in financials prior to the expected profit taking. (For more, see Finding Short Candidates With Technical Analysis.)

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