Whiskey and Gunpowder editor Dan Amoss says the recent rally in financial stocks has more to do with short covering than regular buying.

Weak institutions were shorted so much that a bounce was inevitable.

Despite an SEC clampdown on shorting, Dan says legitimate shorting is vital for the stock market and is not to blame for the stategic mistakes of U.S. banks.

For those still looking for new short ideas in the sector, Dan says Allied Capital (NYSE:ALD) is a good place to start…

The recent financial stock rally has all the signs of panicked short covering, rather than typical buying. Consider how the depository institutions most likely to eventually join IndyMac (OTC:IDMC) in federal custody – including Washington Mutual (NYSE:WM), Downey (NYSE:DSL), and Huntington Bancshares (NASDAQ:HBAN) – are rallying the most. So many shares had been sold short that a violent rally was inevitable.

Eventually, though, this rally should prompt two things:

1. Mutual funds selling financial stocks into strength. We’ve finally seen a shift in psychology away from buying financials on the dips. Many managers are preparing for an extended bear market in the sector.

2. Banks with capital shortfalls will announce secondary stock offerings. This will lower the cost of new capital, because higher stock prices allow the banks to issue fewer shares to raise a fixed amount of capital.

The SEC is implementing rules that will make it a bit harder to sell short stocks that are difficult to borrow.

I think “naked” short selling (shorting a stock when your broker has not yet located shares to short) must be stopped. This practice gives legitimate short selling a bad name.

Stock should be located and borrowed before it is sold short, not the other way around. If your broker cannot locate shares to short, you should move on to another idea, or use put options.

But the hysteria about “rumors” bringing down financial companies has gone too far, I think. This is the defense of CEOs who are looking to blame someone for their own incompetence – incompetence that put their firms in a vulnerable position in the first place. Short sellers did not conspire to force Wall Street firms to enter the business of securitizing dodgy debts. Firms like Bear Stearns ruined their own companies with the poor strategic decisions they made. The free flow of opinions is vital for the health of the stock market. One should be very suspicious about executives who try to suppress any negative opinions about the value of their stock. Allied Capital (NYSE:ALD) comes to mind.

You can read about Allied’s crusade against David Einhorn in his excellent book, Fooling Some of the People All of the Time.

Allied is still a good short idea looking out beyond a year because it’s running out of attractive assets to sell and finding it harder and harder to issue new equity.

Short sellers need to do their own fundamental research and form their own opinions. Only fools buy or sell short stocks based solely on rumors. Legitimate short sellers are very beneficial for the market. They provide liquidity at market bottoms by buying to cover their positions, and they are often the first to discover and put an end to accounting frauds and stock promotion schemes that siphon capital away from legitimate businesses.

Timing is important in the banking business. Also, as in investing, it pays to be a smart contrarian. Ideally, banks should make as many loans as possible once the economy bottoms. In an improving economy, borrowers can more easily pay down debts.

Loans made with disciplined underwriting guidelines ahead of an economic boom can be both safe and profitable.

On the other hand, aggressively expanding a loan book at the peak of a credit cycle and an economic cycle can lead to disaster.

Once credit cycles turn, loan portfolios, or loan books, become sources of risk, rather than profit. Look at the experience of Countrywide, which just got acquired by Bank of America (NYSE:BAC) for a fraction of is peak value. It blew itself up by aggressively expanding its mortgage loan book at the peak of the credit cycle – which happened to coincide with the biggest housing bubble in history.

Source: A New Short Idea in the Banking Sector