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.#-ad_banner-#

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.