Since the second half of 2012, bank stocks have really found their footing. Shares of Citigroup (NYSE: C) and Bank of America (NYSE: BAC) have rallied more than 50% in the past six months, adding tens of billions to their market valuations.

To be sure, these two banks were so sharply undervalued when 2012 began -- at least in relation to book value -- that they were bound to rise. Yet even stronger banks such as JP Morgan (NYSE: JPM) and Goldman Sachs (NYSE: GS) have seen their shares rise more than 30% in the past two quarters.



"The price moves reflect increasing confidence in the housing recovery and optimism around the economic outlook for 2013 in general," noted UBS' Brennan Hawken. In a hopeful sign for continued gains, these banking stocks are off to a solid start in 2013 as well.

Yet investors in this sector need to take note of an ominous development. Short sellers have begun to pile into a leading bank stock and a leading bank exchange-traded fund (ETF) -- at a fairly aggressive pace. Here's a quick snapshot of the latest short interest data, which was released on Dec. 26, 2012.



Short sellers are clearly targeting the Financial Select Sector SPDR (NYSE: XLF). Wells Fargo (NYSE: WFC), JP Morgan and Berkshire Hathaway (NYSE: BRK) are the top-three positions, each representing roughly 8% of the fund, while Bank of America (NYSE: BAC), Citigroup (NYSE: C) and U.S. Bancorp (NYSE: USB) each account for more than 5% as well.

What the short sellers are focusing on
Well, a few theories have emerged. The first one relates to profit forecasts for the next few years. Banks have seen a steady erosion in their lending spreads, which is known as their "net interest margins" (NIM). NIMs are expected to remain weak in 2013, but analyst forecasts for 2014 imply a stabilization in the NIM. That's because interest rates are expected to rise, which tends to allow banks to raise lending rates at a faster pace than the rates they offer savers. And this widening spread would help offset other factors such as regulatory changes, which continue to weaken the NIM.

Citigroup's Keith Horowitz says the Federal Reserve will stick with a policy of low rates for quite a while to come -- certainly beyond the end of 2013. "2014 estimates assume NIM compression slows down, which we see as unlikely in a low-rate scenario, putting 2014 EPS estimates at risk," Horowitz said. He suspects regional banks US Bancorp, Keycorp. (NYSE: KEY) and First Horizon National (NYSE: FHN) are at the greatest risk of 2014 earnings per share (EPS) reductions.

Why shorts might be targeting the banks
History says they are due for a breather after a strong upward move. If the banks can maintain their current New Year rally, then "2013 will represent the fifth year of the bank stock rally from its 2009 trough, and the S&P Bank Index is up 226% since. In the early 90s, bank stocks returned 180% in its four years from the trough -- implying that this decade's stock recovery has come faster," according to Merrill Lynch's Erika Penala. She adds that the "risk-on" nature of the market in recent months has been helpful to riskier sectors such as banks, but "we would not rule out a pick-up in volatility due to a replay of the disorderly debt ceiling negotiations witnessed in '11 as we move closer to the current February end deadline."

There is perhaps another more prosaic reason why short sellers may be targeting XLF. The U.S. economy remains vulnerable to another downdraft, especially at the corporate level. Even as bright spots in the economy such as housing emerge, key gauges of corporate confidence, such as the monthly reading of the National Federation of Independent Businesses (NFIB) have been increasingly glum. Bank stocks would likely give up much of their 2012 gains if the economy stumbled anew.

Risks to Consider: As an upside risk, the housing market could get yet stronger in coming months, leading analysts to boost their forecasts for mortgage underwriting activity at banks.

Action to Take --> The upcoming earnings season is likely to hold few surprises for bank stocks. Quarterly results are likely to be roughly in line with analysts' forecasts, as has been the case for a number of quarters. Instead, it is the looming government budget talks that could create real noise for this group. Many suspect we'll get a lot of stomach-churning headlines in February, as the March 1 debt ceiling deadline approaches. And bank stocks won't be a safe haven if the seas get rough. At least that's what the short sellers seem to be anticipating.

Related Articles
  1. Chart Advisor

    3 Ways to Trade the Rising Volatility

    With volatility increasing in the markets, many are turning to these three volatility-capturing exchange-traded products.
  2. Mutual Funds & ETFs

    ETF Analysis: iShares US Basic Materials

    Learn about the iShares US Basic Materials exchange-traded fund, which invests in the equities of chemicals, metals and industrial gas companies.
  3. Mutual Funds & ETFs

    ETF Analysis: Ultra Oil & Gas

    Find out more about the ProShares Ultra Oil & Gas exchange-traded fund, the characteristics of the ETF and the suitability and recommendations for the fund.
  4. Mutual Funds & ETFs

    ETF Analysis: PowerShares DB Commodity Tracking

    Find out about the PowerShares DB Commodity Tracking ETF, and explore a detailed analysis of the fund that tracks 14 distinct commodities using futures contracts.
  5. Mutual Funds & ETFs

    ETF Analysis: PowerShares FTSE RAFI US 1000

    Find out about the PowerShares FTSE RAFI U.S. 1000 ETF, and explore detailed analysis of the fund that invests in undervalued stocks.
  6. Mutual Funds & ETFs

    Comparing ETFs Vs. Mutual Funds For Tax Efficiency

    Explore a comparison of mutual funds and exchange-traded funds, or ETFs, and learn what makes ETFs a significantly more tax-efficient investment.
  7. Mutual Funds & ETFs

    ETF Analysis: Vanguard Small-Cap Value

    Find out about the Vanguard Small-Cap Value ETF, and explore detailed analysis of its characteristics, suitability, recommendations and historical statistics.
  8. Mutual Funds & ETFs

    ETF Analysis: Vanguard Intermediate-Term Corp Bd

    Learn about the Vanguard Intermediate-Term Corporate Bond ETF, and explore detailed analysis of the fund's characteristics, risks and historical statistics.
  9. Insurance

    Whole or Term Life Insurance: Which Is Better?

    Learn the difference between term life insurance and whole life insurance. Understand when it is beneficial to buy each type of life insurance.
  10. Mutual Funds & ETFs

    ETF Analysis: iShares 10-20 Year Treasury Bond

    Learn about the iShares 1-20 Year Treasury Bond ETF and its holdings, and understand why investors may be better served to look at other bond funds.
RELATED TERMS
  1. Equity

    The value of an asset less the value of all liabilities on that ...
  2. Exchange-Traded Fund (ETF)

    A security that tracks an index, a commodity or a basket of assets ...
  3. Exchange-Traded Mutual Funds (ETMF)

    Investopedia explains the definition of exchange-traded mutual ...
  4. Fractal Markets Hypothesis (FMH)

    An alternative investment theory to Efficient Market Hypothesis ...
  5. Hard-To-Sell Asset

    An asset that is extremely difficult to dispose of either due ...
  6. Sucker Yield

    When an investor has essentially risked all of his capital for ...
RELATED FAQS
  1. How do dividends affect retained earnings?

    When a company issues a cash dividend to its shareholders, the retained earnings listed on the balance sheet are reduced ... Read Full Answer >>
  2. What is the difference between called-up share capital and paid-up share capital?

    The difference between called-up share capital and paid-up share capital is investors have already paid in full for paid-up ... Read Full Answer >>
  3. Why would a corporation issue convertible bonds?

    A convertible bond represents a hybrid security that has bond and equity features; this type of bond allows the conversion ... Read Full Answer >>
  4. What does a high turnover ratio signify for an investment fund?

    If an investment fund has a high turnover ratio, it indicates it replaces most or all of its holdings over a one-year period. ... Read Full Answer >>
  5. Does index trading increase market vulnerability?

    The rise of index trading may increase the overall vulnerability of the stock market due to increased correlations between ... Read Full Answer >>
  6. How does additional paid in capital affect retained earnings?

    Both additional paid-in capital and retained earnings are entries under the shareholders' equity section of a company's balance ... Read Full Answer >>

You May Also Like

COMPANIES IN THIS ARTICLE
Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!