Ups and Downs of Financial Stocks

The week after Thanksgiving began with Abu Dhabi buying 4.9% of Citigroup. Financial stocks subsequently led a raging two-day market rally, then gained even more on news of a possible plan to freeze interest rates on high-risk adjustable mortgages.

Some of the bank stocks that had been among the weakest performers, such as Washington Mutual (symbol WM) and IndyMac (IMB), rallied by about 10% on November 30. Shares of such solid citizens as Wells Fargo (WFC) and Bank of America (BAC) also had their best weeks in a while.

The rally in bank stocks, along with a decline in oil prices, from a shade under $100 a barrel to about $90, helped push up the broad market indexes.

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But it will take more than news of a junk-mortgage rescue plan to sustain a recovery in bank stocks. For that to happen, the Federal Reserve will have to keep slicing short-term interest rates, not just once more, but several more times.

It also will require the economy to stay out of recession or near-recession. If it does, investors will become more confident about the sector's 2008 earnings outlook and feel more assured that banks won't have to cut their high dividends. None of this is guaranteed to happen.

Yes, Federal Reserve chairman Ben Bernanke says the consumer economy still faces headwinds. That's interpreted as a sign that he's open to more rate cuts. But based on comments by other Fed officials, it's not clear that all the central bankers are singing from the same hymnal.

And if the problem for banks is that consumers are struggling to pay their mortgages or their credit cards, or both, the Fed's rate actions are besides the point. Banks tend to toughen the terms on delinquents, not ease them in concert with the Fed's thinking.

Prospects for other parts of the financial sector are mixed. Credit Suisse analysts, for example, remain cautious on big and small banks, real estate investment trusts and insurance companies.

The REITs and regional banks (which mostly deal with consumers and small businesses and engage in real estate lending) appear cheap. But until real estate development picks up, opportunities for growth are limited.

Investment banks are dealing with management issues, shrinking availability of credit for mergers and buyouts, and unexpected annoyances, such as a sudden slowdown in the issuance of municipal bonds.

Insurance has winners and losers. On any given day, a great stock like Principal Financial (PFG), which is up 12% for the year, will plunge on a profit warning tied to slowing growth in stock and bond returns. It happened post-Thanksgiving Day, with Principal's shares losing nearly 10% even as bank stocks were soaring.

On the other hand, AIG (AIG), which was once a great growth company but is now a trading stock, leaped from $52 to $58 despite a negative report by UBS Securities that highlights the ongoing risks in AIG's massive holdings of "credit default swaps" and subprime mortgage pools. At an investor day that AIG is planning to hold on December 5, the company will presumably try to persuade analysts why it won't have to take any more massive write-downs. If it can't, one week's 10% gain becomes the next week's 10% drop.

The market conditions that have knocked so much stuffing out of bank and other financial stocks may be easing. Or maybe not. For example, commercial real estate is peaking, but residential is still hurting. There's fear that credit-card profits will suffer from a rise in delinquencies. And Wall Street isn't ready to declare that the war on subprime is winnable.

Unfortunately, any one of these issues can hurt a long list of stocks. They also suggest that the financial sectors, as well as the whole market, will be subject to big daily price swings. In the last week of November 2007, this volatility was to the good. The next round of volatility could be painful.