Bulls Trample Recession Fears

But financial stocks have lost much of their post-rate-cut shine.
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Emboldened by last week's Fed rate cut, stock market bulls continue to shrug off warnings that the economy is slowing.

It seems the Federal Reserve's 50-basis-point rate cut provided enough confidence to unlock the seizure in the credit markets that took hold in July and August. Libor, the market-driven overnight lending rate between banks, has fallen, as have rates on short-term commercial paper financing. Some LBO-related loans are moving off brokers' books as junk-rated credit market spreads narrow.

Stories continue to emerge about vulture investors saving the day, like Wednesday's news of potential buyers for

Bear Stearns

(BSC)

, the market's poster child for poor structured finance risk management.

The stock market is certainly happy. Since the Federal Reserve's surprising 50 basis point rate cut last week, stocks have rallied almost without respite. The

Dow Jones Industrial Average

is up 3.4% since the day before the Federal Reserve's meeting.

"The Fed gave the market everything it wanted," says Richard Sparks, senior equities analyst and options trader at Schaeffer's Investment Research.

Perhaps investors fear missing out on a rally that has mostly continued throughout the past year despite credit market froth and the housing market's collapse. There's the notion that after losing a lot of returns in the summer, it's too risky not to be in the stock market, says one trader who declined to be named. Sparks would say the very caution in such a sentiment is what keeps the market climbing. It's when sentiment gets overheated with optimism that market tops happen.

"It is widely believed the Fed would provide additional liquidity ... if necessary," says Mike Malone, trading analyst at Cowen & Co. He adds that investors feel confident that if the Fed's action can "bring the economic slowdown back to just housing, that's a positive."

One possible problem is that the slowdown's not just back to housing. Sure, the existing home sales report out Tuesday was grim, and that was no surprise. But Wednesday morning's report that durable goods orders fell 4.9% in August went beyond expectations for a 3.5% decline. That shortfall doesn't provide much optimism for the future.

"The risks lie in the direction of greater weakness this fall, as the full effects of recent financial market turbulence are felt," writes Peter Kretzmer, senior economist at Bank of America. He notes also that Wednesday's weak report does not bode well for business spending in the second half of this year.

Even within the stock market, cracks are emerging in the thesis that the rate cut solved the economy's problems. The housing sector and many of the financial stocks, which were expected to be most rewarded by new Fed-driven liquidity, are quickly retreating or already below their pre-rate cut levels.

For example,

Lehman Brothers

(LEH)

, which ostensibly reported better than expected earnings last week, is trading 8.7% lower than its post-Fed pop.

Morgan Stanley

(MS) - Get Report

, whose earnings were not as cheered last week, is trading below its pre-Fed meeting price, and 9.8% below its post-Fed high.

Likewise, the housing sector as measured by the Philadelphia Homebuilder Sector Index is trading below its pre-rate cut level, and 13% below its post-Fed rate cut high.

"Something just ain't right," says Randy Diamond, trader at Miller Tabak.

Last, earnings are expected to be the worst in five years this quarter. Granted, it's almost a cliché to suggest that the coming quarter's earnings season will be weak, as analysts have perpetually underestimated earnings that ran at double digit growth for 14 straight quarters through the first quarter of 2007. But, as the third quarter draws to a close, Standard & Poor's is taking the negativity one step further.

S&P says third quarter earnings growth will be the lowest in five years, clocking in at a 2.4% rate. According to S&P analyst Howard Silverblatt, "you can't have a good quarter without financials." The sector contributes 28% of the S&P 500's earnings, and it is expected to log a decline of 2.9% in the third quarter, he says.

Silverblatt also warns that some financial companies have adopted new accounting rules. This could lead to some write-offs tied to "bad loans or doubtful accounts," or to "mark to market appraisal value" of unmarketable securities, among other classifications.

Thomson Financial puts the consensus of analysts' earnings estimates at 4.4% growth this quarter, but the firm agrees this is the lowest estimate in five years. Thomson estimates financial sector profits will grow by 4% in the quarter.

In keeping with TSC's editorial policy, Rappaport doesn't own or short individual stocks. She also doesn't invest in hedge funds or other private investment partnerships. She appreciates your feedback. Click

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