Is the bank stock rally over?
Bank stocks have cooled in recent days following a two-month-long rally. The direction from here, however, may hinge on what's next for the U.S. economy.
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| A murky economic outlook may spell more volatility in the months ahead for bank stocks. |
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| The S&P Bank index enjoyed a nice bounce in March and April, but remains well below where it was just six months ago. |
NEW YORK (CNNMoney.com) -- The recent bank stock rally may have finally run its course.
After bottoming out in early March on fears that some of the biggest banks were insolvent, shares across the sector skyrocketed before government regulators finally unveiled the findings of their stress test program for the nation's largest financial firms in May.
Since then, however, investor interest in banks has cooled considerably. Two of the most widely-watched barometers of the sector - the KBW Bank Index and S&P Banking Index - have each fallen more than 10% since the stress test results were announced and remain well below where they were trading back in mid-September before the collapse of Lehman Brothers.
Lenders that enjoyed the biggest returns during the months of March, April and early May, such as Citigroup (C, Fortune 500) and Bank of America (BAC, Fortune 500), have taken a hit in recent days.
Citigroup fell again Monday, despite a broad market rally, on the news that it was being removed from the Dow Jones industrial average. Ironically, it is being replaced by the Travelers Companies, a leading insurer that once was part of Citigroup.
Big banks aren't the only one suffering from pullbacks. Shares of SunTrust (STI, Fortune 500) and Regions Financial (RF, Fortune 500), two top regional banks based in the Southeast which were also deemed to be in need of additional capital by the government, are both off more than 30% since the results of the stress test were revealed.
Massive gyrations in the financial sector are hardly a new phenomenon. For nearly a year now, bank stocks have endured wild swings, falling as much as 25% in a single trading session.
Still, those who track the industry tend to agree that investors are now viewing bank stocks differently.
Blake Howells, director of research at Portland, Ore.-based Becker Capital Management, which oversees $1.7 billion in assets, said investors are now more focused on whether banks can return to normal, stable earnings growth, rather than fears about nationalization and an institution's solvency.
Some critics insist that the surprisingly strong numbers generated by large lenders in the first quarter were exaggerated as banks tried to pass the government's stress test. A surge in mortgage refinancing activity did not hurt either, although that is a trend that many analysts see as unsustainable -- especially since mortgage rates have been rising in the past few weeks.
Banks also remain saddled with loan portfolios that are ripe for further losses, particularly in areas like commercial real estate. The percentage of construction and development loans that were 30 to 89 days past due climbed to 3.56% from 2.92% during the first quarter, according to figures published last week by the Federal Deposit Insurance Corporation.
"Credit trends are negative across the board whether you are a community lender, regional or national bank," said Eric Hovde, chief executive of Hovde Capital Advisors LLC, a money-management firm in Washington that focuses on the financial services sector.
Of course, other factors could figure into bank stock performance in the coming quarters, including future actions by the government. Banks with sizable credit card businesses suffered somewhat of a setback last month following the passage of legislation that reined in lenders' credit card practices.
There is also widespread speculation that banking regulators could take a hard line on the industry, demanding that lenders, for example, hold more capital on their books to compensate for future losses. That could crimp profitability.
Others have a less dire view however. Bank stock bulls contend that the worst may be over for many lenders, as some banks have, and will continue to, aggressively reserve for future losses.
The increasing number of signals that the nation's economy may finally have reached a bottom is also encouraging for the industry.
Weekly figures on first-time unemployment claims, often viewed as a real-time assessment of labor conditions, have started to slow in recent weeks even as continuing claims remain at historic levels.
Activity in the manufacturing sector has also been on the mend in recent months, according to recent readings by the Institute for Supply Management.
The emergence of such signals foreshadowed an economic recovery in five of the last recessions dating back to the 1970s, notes Peter Winter, managing director at BMO Capital Markets. Winter upgraded a number of regional banks two weeks ago, including U.S. Bancorp (USB, Fortune 500) and California-based lender EastWest Bancorp (EWBC).
Should a similar trend occur this time around, that would certainly bode well for the more than 8,200 lenders that make up the nation's banking system and the roughly $13.5 trillion in assets they control.
But investor confidence in the banking sector, much like the U.S. economy itself, remains shaky at best, setting up what most analysts believe will be another volatile, albeit more modest, period for bank stocks.
"Unfortunately the group is going to trade more on economic news than anything else, at least in the near term because the recovery is tentative," said Winter.
Of course, some lenders are widely believed to be better positioned than others to navigate the current environment, including JPMorgan Chase (JPM, Fortune 500) and U.S. Bancorp, two banks that were deemed not to need any additional capital by the government.
Their position of strength may translate into stable stock performances rather than outsized returns though. Part of that is due to the fact that healthier banks didn't fall as sharply as weaker lenders.
For that reason, Howells of Becker Capital Management, whose firm owns shares of U.S. Bancorp and JPMorgan Chase, said some of the undercapitalized regional lenders could enjoy the biggest bounces going forward.
Some of those bets could misfire, Howells said. But he added that it is not farfetched to think that Fifth Third (FITB, Fortune 500) or KeyCorp (KEY, Fortune 500) -- two Ohio-based banks that were also told by the government to raise capital -- or Regions Financial could double in price before long. 
