itself can regain positive momentum, Wall Street strategists agree, and that bodes ill for equities.
"Stabilization of financial stocks is imperative to market health and required for any long-term rally," said Jeff deGraaf, a technical analyst at Lehman Brothers in New York. "Financials don't have to rally first, but there has to be some sense that they won't continue to decline."
Like a barometer signaling a change in the weather, bank stocks portend trends in the general market by as much as a year.
The all-time high on the Standard & Poor's bank index occurred July 14, 1998 -- a year ahead of the peak in the broad-market S&P 500 stock index on July 16 of this year.
And the bank index peaked this year on May 3, 10 weeks ahead of the S&P 500 and 16 weeks ahead of the much-watched Dow Jones industrial average.
"These stocks warned of a market top, and can also signal a bottom by holding their own or even moving up while the rest of the market is still heading lower," said Gail M. Dudack, chief equity strategist at Warburg Dillon Read in New York.
Commercial banks are the primary pipeline for monetary policy, and thus are the first to be directly affected by changes in money supply, interest rates, and foreign exchange rates. They act as a buffer between monetary policy and the real world. Eventually, producers of tangible goods, whether housing or bagels, feel the effects, and that is why financial stocks are the precursor to the overall market.
A near-term pickup in interest rates and currency rates is not a given, however, with the Federal Reserve still in a tightening mode and foreign economies gaining steam. "Better global growth, while good in itself, means higher interest rates and a weaker dollar," said Ms. Dudack, who regularly appears on the television show "Wall Street Week." She said she thinks the correction in the overall stock market is about half over in both time and depth.
Several banking industry analysts said they are not convinced that this week's three-day rally in banking stocks suggests an imminent turnaround for the sector, which would in turn be a harbinger of better days ahead for other stocks.
"It's pretty obvious to us that we are in a bear market for banks, and one could argue that the overall market is in bear territory," said Anthony J. Polini of Advest Inc. "We think it will probably get worse before it gets better."
He advised clients to sell on this week's strength in bank stocks, after reports of good third-quarter earnings. "The rally has been justified by good fundamentals, but we still think it will be possible to buy bank stocks more cheaply later in the year," he said.
Mr. Polini's longer-range view is also cautious. "More and more every day, I believe bank stock performance is telling us that we are overdue for a recession," he said. The current economic expansion has now lasted an extraordinary eight and a half years.
"Banks have chronically underperformed for the past 15 months, and these stocks are among the best economic indicators," Mr. Polini said. "But they tend to be ignored when everyone is caught up in an emotional state, like greed or fear," he said, referring to the supposed twin catalysts of the market.
"If our scenario is right, the overall market could pull back another 10% to 15% while banks pull back less after the distance they've already traveled -- maybe half that much -- and then they would be set to outperform," he said.
Credit Suisse First Boston analyst Michael L. Mayo, who has been cool on prospects for bank stocks since last year, said his views remain unchanged. "The quality of earnings is less than what it had previously been," he said.
"What we saw in the third quarter was above normal reliance on equity gains -- venture capital gains alone totaled almost $2 billion at the seven largest banks, reflecting their degree of dependence on the stock market for earnings," he said.
"Second, problems in the domestic commercial loan category continued to increase, albeit modestly," he said, "but this is while the economy is still growing very strongly," he noted. "Third, there has been some impact of higher interest rates in more subdued trading, higher funding costs, less mortgage-related activity, and in some cases securities losses."
Also offering a guarded outlook were the bank analysts at A.G. Edwards & Sons in St. Louis, who "remain concerned that fundamental issues of deteriorating earnings and credit quality will continue to weigh heavily on valuations." Indeed, they said, underperformance by bank stocks versus other stocks over the next year "remains a real risk."
Dwindling loan-loss reserves "have been an indirect source of earnings growth for much of the industry," David C. Stumpf, Timothy W. Willi, and Diana P. Yates pointed out in a recent update for clients. "Without much of a cushion left in current reserve levels, we believe that even a simple return to more normalized credit losses would prove to be problematic for many bank stocks."
They cited "a growing number of cases of financial engineering among banks," including reducing loan-loss reserves and realizing securities gains, but cautioned that these tools are becoming steadily less available.
