Growing Credit Worries May Snuff Out Stock Market Rally

Early earnings reports from the nation's biggest banks are showing that there's still one major hurdle the market needs to overcome before a recovery can be taken seriously.

Credit concerns, be they at the consumer or commercial level, continue to bedevil banks and the broader economy.

As unemployment continues to grow and the real estate contagion spreads to the commercial sector, institutions like Bank of America , which reported earnings Monday that reflected intense credit pressures, will continue to struggle.

"We have been and remain cautious on financials and banks in particular. That's our stance for well over a year," said Gary Flam, portfolio manager at Bel Air Investment Advisors in Los Angeles. "This rally not withstanding, we continue to hold that negative stance and it's because of those credit concerns."

On their surface, BofA earnings easily beat Wall Street estimates with a profit of 44 cents per share against expectations of just 4 cents.

But the company set aside $13.38 billion in losses for the quarter, and a statement from CEO Ken Lewis that the bank faces "extremely difficult challenges, primarily from deteriorating credit quality," was seen as reflective of other similar institutions. Stocks across the sector plunged Monday.

The commercial loan and real estate operations are seen as particularly weak as that part of the real estate market is expected to come under intense pressure through 2009.

"BofA is a better barometer than what you saw last week from a Goldman Sachs and maybe even a JPMorgan," Chris Mutascio, banking analyst for Stifel Nicolaus in Baltimore, told CNBC (see video). "This is an indicator of what we're going to see in the commercial and commercial real estate portfolios and the loss rates that are rising, and I don't think that bodes (well) looking at the sustainability of earnings."

Goldman Sachs (NYSE: GS), JPMorgan Chase (NYSE: JPM) and Citigroup (NYSE: C) all have reported in the past week, also beating the Street, but investors showed concern that while the banks are showing decent operating profits their underlying financial health is still being hit by deteriorating credit conditions.

State Street (NYSE: STT), Morgan Stanley (NYSE: MS) and Fifth Third (NASDAQ: FITB) report later in the week, and analysts will be watching closely to see what their numbers hold. In all, 25 percent of the S&P 500 reports this week.

In a research note, Goldman singled out Citi for the problems it is having in accelerated credit losses and said the credit issues and other problems "muddied the waters in assessing the franchise's underlying performance."

Those types of worries are just the kind of thing that can stop a six-week stocks rally in its tracks.

"We got way ahead of ourselves in the market," said David Twibell, president of wealth management for Denver-based Colorado Capital Bank. "It's been wonderful to see, but I don't think anybody knows what we really have right now--if this is a bear market rally--until there's a pullback. We'll see whether capital re-enters the market when we see that pullback happen."

Indeed, while the market recoiled sharply on the news from BofA and further indications that the government is moving closer to nationalizing the banking industry, it was too early too tell whether it was simply a natural snapback from a prolonged rally or indicative of something more ominous for the market.

Bullish investors have been hoping the March 9 lows hold, and it would take a string of days like Monday to break those levels.

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"I'm not willing to say the worst is over from a credit-loss perspective," Mutascio said. "I think the rally in the last several weeks on the thought that we're going to have a 'V'-shaped recovery and credit quality is going to be fine, I think is a bit misleading.

"We think we're going to see a bit of a pullback, but I don't know that we're going to retest the lows that we saw on March 9."

At the same time, risk tolerance remains low for bank stocks.

"I don't think we've really reached a point where investors know how those portfolios are going to act over the next four to six quarters," Flam said. "Where will be peak losses, at what level? How does that curve look? I still don't think we've gotten clarity from that aspect."

The prevailing hope among investors is that the sector can at least stabilize, even if it doesn't shoot higher and act as a leadership for the market out of the recession.

After all, the industry should regain its footing at least in terms of lending, what with being able to borrow money at practically zero interest and send it out to consumers at 4 or 5 percent and higher. That creates an upward-sloping yield curve that translates into an operating profit, even if overall fiscal health suffers from credit pressures.

"It's great to see that they're making money," Twibell said. "The real issue to me is asset quality, not their ability to post a profit in any particular quarter."

The upshot of the dichotomy between earnings and lingering credit troubles is that investors remain cautious on bank stocks, even if their view of the market overall stays fairly optimistic after the March lows were put in.

"From a broader perspective we are constructive on the market. We think the market ends higher than the current levels," Flam said. "It's just going to be a volatile year. Investors have to be cognizant of that--use weakness to their advantage and be disciplined."

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