Could the rally have just been a mirage?

The recent surge in bank stocks has been one of the few bright spots in otherwise dismal times for the industry, but it may disappear next week with the start of third-quarter earnings announcements.

The sector could see a 5% to 10% correction from current levels, as investors are reminded that banks are not totally out of the woods in terms of asset quality, said Frank Barkocy, the director of research at Mendon Capital Advisors.

Though banks' margins likely have improved and early delinquencies on loans probably have eased, loan-loss reserves are expected to remain at high levels, Barkocy said.

"The fundamentals for the third quarter are going to be really mixed," and the correction would be "a function of the earnings as well as the mixed economic data," he said. "The wild card is the regulatory climate — what may be forthcoming in the coming weeks out of Washington."

As banking firms seek to pull themselves out of the financial crisis, strong stock prices have even more benefits than usual. They can counter the dilutive effects of capital offerings, entice investors to participate in more capital raises and — if merger activity picks up in coming years as expected — improve a bank's power to make acquisitions or fend off takeover bids.

Jeff Davis, an analyst at FTN Equity Capital Markets Corp., said many large banks announced their bad news in earlier quarters, but more surprises could come from regionals and smaller banks that are now being scrutinized much more heavily. Two such companies — Marshall & Ilsley Corp. and United Community Banks Inc. — have already warned that their third-quarter results would be below the Wall Street consensus because of higher-than-expected credit costs.

A number of regionals such as Zions Bancorp., KeyCorp, Comerica Inc. and Regions Financial Corp. may post weak results because of continued asset quality problems, Barkocy said. But then again, if their results are in line with expectations, their stocks may not suffer as deep of a dive as others who post negative surprises.

The banking companies considered the "safety" stocks will continue to trade better than the sector. These include custodial companies such as State Street Corp. and Bank of New York Mellon Corp. as well as the "winners" that have not been as hard hit with asset problems as others, including JPMorgan Chase & Co., Goldman Sachs Group Inc. and U.S. Bancorp, Davis said.

Once the third-quarter results are digested and stocks have taken their hits, the upward trend could resume, analysts said.

Though the KBW Bank Index rose 36.2%, to 47.46, from June 22 to Sept. 21, it has only partially recovered from the free fall induced by investor panic and short-selling during the heart of the financial crisis. The index closed Wednesday at 47.08.

The index has only increased 1% since the beginning of the year, and needs to more than double just to trade at the levels it did two years ago.

Moreover, many bank stocks still trade below value and the average price-to-book ratio is only 114%, compared with the 150% average ratio in a more-normalized earnings environment, Raymond James & Associates analyst Anthony Polini said.

By next summer, more than a few bank stocks could start to soar, as the economy recovers and their earnings double or even triple.

Until then, the rebound in the sector will likely be muddled — but steady — analysts say, if banks start posting more normalized earnings in a slow-growth recovery and investors expect even stronger long-term results.

"Stocks have always led the fundamentals — stocks are always going to be six-to-12 months in front of the numbers," Davis said. "The market is telling us that, for many companies, the numbers are going to start to improve next year."

Polini said that the banking sector will soon reach an "inflection point," when credit quality stabilizes and earnings and revenues become more normalized. The economic recovery will likely be slow, but that type of environment actually bodes better for many banks than a faster-growth recovery.

"In a slow-growth environment you tend to get better spreads, lower interest rates and less competition," Polini said. "If it's a faster-growth recovery," the Federal Reserve "might start raising rates sooner rather than later and the environment might wake up marginal competitors that tend to come back into the market when things are good."

Companies that should "thrive" in such an environment include Wells Fargo & Co. and Bank of America Corp., and their stock performance over the next year should reflect that, Polini said.

B of A and Wells, he said, have business models that enable them to thrive in a slow-growth recovery: they are well diversified in consumer and commercial products; they have market dominance in part through recent major acquisitions; they have higher spreads; and they are good cross-sellers, enabling them to garner more revenue per customer.

Rochdale Securities analyst Richard Bove said a number of bank stocks that are now a bit overpriced because of "indiscriminate" buying within the sector, may recede somewhat after they post third-quarter earnings, including KeyCorp, Comerica, Regions and Fifth Third Bancorp.

But looking out to the summer of 2010 after — one hopes — the unemployment level improves and the economy recovers, the sector should do "extraordinary well" as many banks double or triple their earnings, Bove said. Such an expansive period could last as long as 2013, he predicted.

But Bove warned that expansion may be stymied if many of the regulatory reform proposals currently circulating in Congress are enacted, particularly regarding the creation of a new consumer financial protection agency and the prospect of higher capital requirements.

"If any bills that have been put in front of Congress actually get passed, there is no question that the ability of banks to grow will be seriously hampered," he said. "Therefore, after this burst of earnings activity and burst of stock prices, then stocks will stall and be down for a long, long time."

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