No joke: Bank stocks are rallying

The S&P Bank Index and KBW Bank Index have enjoyed a late-summer surge despite continued fears about Fannie Mae and Freddie Mac and a weakening economy.

J.P. Morgan's dream team

More Videos

NEW YORK (CNNMoney.com) -- Don't look now, but bank stocks are in the midst of a big rally.

Notwithstanding Thursday's painful broader market selloff, shares of some of the largest names in banking are up significantly since mid-July when fears about the health of mortgage giants Freddie Mac and Fannie Mae and institutional failures were at a fever pitch.

Shares of Citigroup (C, Fortune 500) and JPMorgan Chase (JPM, Fortune 500) have risen more than 20%. Others like regional banks Wells Fargo (WFC, Fortune 500) and U.S. Bancorp (USB, Fortune 500), which are both mentioned frequently by analysts as being among the better-managed banks during the credit crunch, have gained close to 40%.

And even beaten down shares of Wachovia (WB, Fortune 500) have recovered nicely, gaining 71% since July 15.

Two of the most closely watched measures of the industry's performance - the KBW Bank Index and the S&P Bank Index - are up 35% and 43% percent respectively as of Thursday.

Of course, bank stocks as a group still remain about 50% below their 52-week highs.

At the same time, not every bank has taken part in the recovery. Shares of institutions perceived to be still in a very tough spot, such as savings and loan Washington Mutual (WM, Fortune 500), have only enjoyed a modest bounce.

Still, shareholders owe a debt of gratitude for the recent rally to fellow investors who covered their short positions and bargain hunters who swooped in in mid-July when bank stocks were at some of their lowest levels in about a decade.

But other factors were also at work.

Assurances by the Treasury Department that it would prop up Freddie and Fannie should the twin mortgage buyers need to be rescued helped restore some confidence in bank stocks. Better-than expected second-quarter results from the industry also has pushed bank stocks higher.

There's also been renewed speculation about industry consolidation, most notably chatter about a takeover of investment bank Lehman Brothers (LEH, Fortune 500). That's given bank investors something to cheer even though many analysts remain skeptical that any big mergers will be announced anytime soon.

"People felt a little more secure," said Clarence Woods Jr., chief equity trader with Baltimore-based MTB Investment Advisors, which oversees about $15 billion in assets and owned shares of JPMorgan Chase as of the end of July.

But this late summer rally isn't the first time that bank investors breathed a sigh of collective relief only to watch their shares get hammered again later.

Earlier this year, shares of many bank stocks rallied by roughly 20% following a rough end to 2007 only to decline steadily thereafter, bottoming out following the implosion of Bear Stearns in March.

The industry staged another double-digit recovery shortly thereafter, climbing 14% between mid-March through May, only to sink to new lows by mid-July.

Bank stocks could indeed tip back to early summer levels, warn experts like Michael Morris, a senior equity analyst and portfolio manager at Delaware Investments in Philadelphia. But what is different about this recovery, Morris noted, is that it may be more grounded in reality rather than previous run-ups.

Banks no longer suffer the drastic swoons in stock price when, for example, the S&P/Case-Shiller national home price index reveals a double-digit percentage decline in home prices, as it did late last month.

"I think a lot of the housing stuff is priced in based on how some stocks are reacting to news on the housing front," said Morris, whose firm oversees more than $135 billion in assets. "Earlier in the year they were trading as much as 20% [lower] on those announcements."

What bank investors may not be taking into account, however, is the state of commercial lending and the consumer.

As a group, banks have experienced an uptick in the number of bad loans in both categories in recent months as businesses and consumers struggle to meet their payment obligations.

But with increasing signs that the economy is in the dumps, including a sizable jump in U.S. unemployment in August, banks could see further deterioration in the health of their credit card and auto loan portfolios.

"That is the big question: 'Are non-performing assets going to accelerate from these levels?' " said Ralph Cole, a portfolio manager at the Portland, Ore.-based Ferguson Wellman Capital Management, which owned shares of a number of financial services firms including Wells Fargo and Bank of America as of the end of June.

Right now, analysts widely expect the industry to disclose some of those very same problems when banks start reporting their third-quarter results a month from now. Financial services firms in the S&P 500 are expected to report a 54% decline in profits from a year ago, according to Thomson Reuters.

As a result, traders are making plenty of bets, notes MTB's Woods, signaling that bank stocks volatility is here to stay at least for the near term.

"We have a lot going on over the next six weeks which will be very crucial to financials," said Woods. "People are playing heavy on both sides."

Fearing that the recovery could be later rather than sooner, Cole is sitting this rally out.

"How can you buy now when the economy is not going to get better for the next three to six months?" he said. "We are staying back - we just don't have the conviction that this is sustainable."