Financials are taking quite a beating these days, not only price-wise, but also in the esteem of stock pickers, dividend investors, the buy-and-hold crowd and pundits alike. And for good reason. The brokers, banks and insurance companies are generally quite suspect. There is no way to know if another shoe (or a bag of shoes) will drop for any one of them.

Bear Stearns was in desperate straits - though well known to the industry - long before we of the public knew. Banks are exposed on subprime, Alt-A mortages, contruction financing on projects that are going to be slooowww sellers. Many large and regional banks, if forced to value assets properly, would have to close their doors. Regulators are looking the other way, and have no choice, in order to give the banks a couple of years to raise capital and outrun their current problems. Insurance companies also have exposure to many of these things. We have a severe information deficit about the financials in general. You and I have no way to know the true extent of these companies’ woes. At this point, I view an investment in most financials the same as diving into an unknown lake - we have no clue where the stumps are, or how many.

As if all this weren’t bad enough, the market has zero tolerance for mystery or goofiness in financials. A financial will sell off on the slightest whiff of negative news - even if not about that company directly and even if not particularly applicable to it. Unless you are intimately familiar with a company, it is healthy and not cutting its dividend, tread carefully. I do have a couple of suggestions below.

While some stocks like Wells Fargo are being touted as recovery plays, I definitely would not go long the stock without SuperPut protection. If truly convinced that a financial has been knocked down to a fire-sale bargain price level, consider instead buying an OTM (cheap) call with an expiration perhaps 3 to 6 months out; or whatever time frame you envision. If the stock recovers as expected, you’ll profit immensely. If it does not, you’re not out much.

Trading Possibilities:
Perhaps it’s one of those fractal things, but every rule has its exceptions, and there are a few good financial stocks. Here are a couple, both of which recently increased the dividend and are not beset by many of the problems afflicting most financials:

Bank of Nova Scotia (BNS) - This Toronto-based megabank operates well over 1,000 branches outside Canada and make a lot of money. It has seriously outperformed its peers and the S&P 500 since 2002. And since 2003, it also has increased revenues, earnings and dividends, with revenues, earnings and dividends expected to continue increasing in the future.

BNS has been falling of late, like most things. It’s no surprise that a financial would have been whacked recently with the market. Technically, the price has touched the 200-MA on a weekly chart and is clinging to the 50-wk average. If if breaks back above the 50-week average (which is also the middle of the Linear Regression channel), it’s a buy.

Banco Santander (STD) - this highly profitable Spanish bank has increased its dividend significantly since 2003, growing revenues and profits as well, and since 2004 has beaten the snot out of both the Large Bank industry and the S&P 500. Technically, it’s at the bottom of its trading channel on both daily and weekly charts…

As Yogi Berra said, you can look it up. Translation: do your own research.

Stock futures are pointing strongly down before the open. The S&P 500, Nasdaq 100 and Dow Jones Industrials all fell this morning, which usually augurs a stock market selloff - just as stock futures strongly up usually mean an up day. This does not mean that the market’s apparent bounce off the bottom of its channel (discussed in my most recent newsletter issue) is invalidated, because an index - like a stock - often needs multiple tests of a support level before it can take off.

Thus if the market does sell off back to the 11,000 level, it is not cause for panic. To the contrary, for the market to find support there again would presage a nice rise back toward the upper channel line.

FINANCIALS:
These are poison for any long stock position until further notice. This goes for all financials - brokers, banks, mortgage-related and insurance. If you assume the other shoe has dropped for Citi and Bank of America, you are gambling. Save it for Vegas. It is not just the subprime, either. Even with my SuperPut strategy (buy a long-term put to protect a covered call position), why buy a stock that poses considerable danger?

HOUSING:
Don’t go there, no matter how tempted by the “bargains” available. The recent “surge” in housing starts was phony, a result of NYC changing its definition of what is considered a housing start. Eliminate that, and housing starts fell.

The big brokers Morgan Stanley (MS), Lehman Brothers (LEH), Bear Stearns (BSC) and Goldman Sachs (GS) all report earnings next week for the quarter. Merrill Lynch (MER) reports in October. These are all important players on the world financial stage. Their financial results will be a good barometer of how bad the credit crunch in past months actually has been. Bear and Lehman have the most exposure to the credit crunch, since they rely more on fixed income sales, which means they heavily sold collateralized mortgage products, but all of them have substantial fixed income sales. The merger and buyout deals generate gigantic fees for these chaps, and the deals have slowed to a crawl as a result of the meltdown. Here’s where the brokers stood as of 9/7/07:

MS - 62.50, down from 90.00 (-30.5%)
MER - 73.20, down from 95.00 (-22.9%)
GS - 179.00, down from 233.00 (-23.1%)
BSC - 105.00, down from 172.00 (-39%)
LEH - 53.00, down from 86.00 (-38.3%)

Several hedge funds have collapsed, notably two run by Bear Stearns. Even Goldman had to pump $2 billion of its own money into one of its big hedge funds after losses in August. Brad Hintz of Bernstein Research (and former Lehman CFO) notes that the big brokers have substantial exposure to subprime because they securitize mortgage loans by cutting them up into tranches and selling the tranches. But the brokers wind up having to take the riskiest tranches that are exposed to the first losses (growing, and they will become gargantuan in 2008), known as residuals. BSC, LEH, GS, MS and MER have as much as $11 billion of these “residuals” on their balance sheets. They also get stuck with leveraged notes and other assets that no one wants now, because one of the ways they get underwriting deals is to take the paper and gamble on being able to resell it.

The market is waiting to see how much effect the crunch will have, how much their asset holdings (which are marked to market) will be devalued, how recent volatility has affected trading profits (they should be up) and how much the slowdown in M&A activity has hurt profits.

Many financial pundits are starting to say that the big brokers are so devalued that they are bargains. Maybe so, but they may be more of a bargain after next week… unless you think they have not been affected by the sheer immensity of the summer’s crunch and the fact that some of their most profitable activities have been virtually stopped dead in their tracks.

Trading and Call Writing
There will be lots of people shorting these stocks (many already have), though it may not be easy. When short interest gets large enough, where will you find stock to borrow? But even your Aunt Mabel can buy puts or place a bear put spread.

Anyone with a covered call on these stocks and who has not purchased a multi-month put to protect the position might consider doing so. Putting a covered call on these stocks requires such a put at this point. If the stock pulls back and catches support convincingly, the put (which will have increased in value with the stock’s drop) can be sold at a profit. Or the put can be exercised if necessary. Unprotected covered calls simply will have to ride it out, although the calls can be traded with the stock’s movement to produce trading profits.

These brokers are some of the most important financial companies in the world, so they are unlikely to vaporize. Bear Stearns is the greater risk and has been scaring people, Lehman is the next most likely to take a large hit. But the problems affecting the brokers are not resolved and not at a crescendo yet, either.

The AUG non-farm payrolls report showed a loss of 4,000 jobs. That might not seem like much, but 1) it was the first negative month in four years, and 2) it was expected that as many as 155,000 new jobs would be added. Thus viewed, AUG showed a rather breathtaking shortfall.

Housing-related industries have lost at least 80,000 jobs this year, and Countrywide (CFC) will itself cut another 10,000 to 12,000 jobs. In fact, the AUG jobs report probably will, more than any other single factor, weigh in the Fed’s decision to cut the fedfunds rate from 5.25%, should they decide to cut it at the September 18th FOMC meeting.

The AUG jobs shortfall is an “economic earthquake” that will dramatically change the Fed’s perspective on the economy, and data to come should start to reveal “how big the ripple effect will be on the economy,” according to Doug Roberts, Channel Capital Research, referring to expected oncoming job losses. Political pressure is mounting on the Fed to cut the fedfunds rate (it only cut the discount-window rate, where non-banks and weaker banks borrow). Federal Reserve Governor Frederic Mishkin recently said that the Fed possesses the “tools to limit the negative effects on the economy from a house-price decline.” Feel better, now?

I for one certainly don’t buy into the notion that the Fed is an all-seeing body (like the Greek gods of antiquity) that can micro-manage human affairs. Notice that Mishkin is not talking about the subprime mess; he specifically limited the Fed’s ability to help to the “house-price” decline. I’m not trying to be niggling, but Mishkin does well to carefully limit his words. Economic tides are too big to be contained by central bank policies, though central bank actions can obviously help or hurt.

A cutback in consumer spending has not yet appeared in corporate earnings. What I really want to see are September jobs reports and Q3 corporate earnings. We’ll have a better handle on things then. If the economy and the credit crunch are in fact derailing consumer spending, then it has to show up in corporate earnings.

DUE NEXT WEEK:
Several reports for AUG are due next week: retail sales, business inventories and industrial production. All are expected to be up 3-5% over July, and shortfalls will be ugly.

From the stocks offering the best call premium, covered call writers select trades (I hope) by choosing the best companies in the best industries in the best sectors. This is the holy grail, even if many of our trades necessarily fall short.

Ah, but where to find good industry info? No one puts it together in any kind of ideal form for covered writers, but there are a lot of good free resources out there. Here are links to the best and most usable web sites:

Yahoo Industry Browser

Yahoo provides almost exclusively fundamental information, but very detailed. Makes you wonder why they stopped there, when there is so much more valuable industry information that traders and investors could use…

Barchart.com Industry Groups

Barchart.com Performance and Fundamental Views

Barchart.com Sector Changes – Ranked by Three Months

The Barchart.com pages are very powerful and offer both fundamental information (and rankings) as well market performance. The Industry Groups page has a chart associated with each industry, which is handy. Some customization is built in; for example, clicking the Sector Name column heading will show industries alphabetically, or you can arrange them by performance over 1, 3, 6 or 9 months, etc. You can also switch between fundamental and market performance views, which is helpful.

Prophet.net Industry Performance

The Prophet.net page’s default setting arranges the industries by stock market performance, with the best-performing industries in green at the top shading to worst-performing (red) at bottom. Click on the industry number code and you get a detailed quote, plus a chart for the industry itself. Prophet.net uses the same Sector/Industry groupings as Yahoo (and CallWriter), which is handy. Click on the industry name and you get a page with charts for all the stocks in the industry. You can arrange the industries by alphabetical or reverse alphabetical order, or by performance. Clicking the “See Current Performance” link on the page gives the same industry performance rank but presents the information from a different perspective. Very cool, and very close to how I would design an industry page.

Morningstar Industry and Sector Performance

Shows both sector and industry information by market performance. Also has performance by company size (Stock Style). Not my favorite, since the same general information is available in more usable form from either Prophet.net or Barchart.com, both of which sites are far more customizable and useful.

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There is some great data at these sites. If you’re wondering why we don’t integrate some of this data into the CallWriter Research page, just stay tuned. Try them out and see what works for you, because nothing else matters. Enjoy.