Don't Bank on Further Gains

Financials' rebound resumes in an otherwise quiet day, but a flattening yield curve looms.
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The major indices were mixed and little changed Thursday, as light momentum and low volume gave the market the dogged feel of a classic mid-August session. Financials, however, continued an uptrend seen since last week as Treasury yields fell. But the group's rebound likely will be short-lived.

The

Dow Jones Industrial Average

rose 4.22 points, or 0.04%, to 10,554.93 as

Altria

(MO) - Get Report

gained more than 4% amid signs a $10 billion verdict against the cigarette maker may be overturned. The

S&P 500 index

fell 1.22 points, or 0.1%, to 1219.02.

The broader market was pressured as more disappointing earnings from retailers further fueled concerns that gasoline prices may be hitting consumers.

Limited Brands'

(LTD)

earnings missed forecasts, as did

Hot Topic's

(HOTT)

, which also trimmed its outlook.

While on a smaller scale, those results reminded traders of

Wal-Mart's

(WMT) - Get Report

warning about its sales outlook, which triggered a 120-point drop in the Dow on Tuesday.

The

Nasdaq Composite

lost 9.07 points, or 0.42%, to 2136.08. The tech-heavy index was weighed down after

Google

(GOOG) - Get Report

fell 1.8% after filing to sell 14.2 million shares in order to raise $4 billion.

Volume was modest, with 1.8 billion shares trading on the

Big Board

and 1.4 billion on the Nasdaq. Breadth on both exchanges was negative, with decliners outpacing gaining issues 19 to 12 on the NYSE and 18 to 11 on the Nasdaq.

Bonds advanced slightly, and stocks briefly spiked, after the Philadelphia Fed's index of regional manufacturing activity rose more than expected in August, while the index's inflation components remained tamed.

The benchmark 10-year bond gained 17/32 and its yield fell back to 4.20%.

With bond yields dropping since last week, supported both by indications of tame inflation and as surging oil prices are more and more expected to tax future economic growth, financial shares also have received a lift.

Banking stocks, in particular, have outperformed the major indices. From Aug. 8 through Thursday's close, the Philadelphia Stock Exchange/KBW Bank Index has gained 0.8%, while the S&P 500 has fallen 0.3%.

Assets & Liabilities

Yet if long bond yields remain low, the upside appears limited for bank stocks for familiar reasons: A flattening of the yield curve, which squeezes most banks' profits, still seems the most likely course of events through the balance of the year.

After their stocks took a beating throughout July, the valuations of most banking stocks do seem attractive.

Citigroup

(C) - Get Report

and

Bank of America

(BAC) - Get Report

, for example, are trading at below-market price-to-earnings multiples while offering higher-than-average dividend yields.

Of course, there are reasons for the corresponding weakness in their shares that led to those seemingly alluring valuations. Second-quarter earnings were weak as most banks continued to feel the pinch of a flattening yield curve. This flattening occurred as the yield of two-year Treasury note is catching up with the yield of the 10-year Treasury bond. (Bank of America is also absorbing its acquisition of

MBNA

(KRB)

.)

Banks typically make more money when the yield curve is steep, as they borrow money at cheaper, short-term rates and lend to consumers or businesses at higher, longer-term rates.

But over the past year, long-term rates have remained stubbornly low even as the

Federal Reserve

has lifted short-term rates 10 times by a quarter-point each. The spread between the yield of the two-year note and that of the 10-year has narrowed from 3.75 percentage points when the Fed began raising rates last year to less than 0.25 percentage point currently.

Among the victims, Citigroup's second-quarter earnings fell below estimates in early July, and the rest of the sector's earnings also failed to impress. Things got worse for banks through July, as strong economic indications -- including the June employment report -- ended hopes that the Fed would stop hiking rates anytime soon.

But after the Fed delivered its 10th rate hike last week, it didn't ring the alarm bells on inflation; bond prices have rebounded sharply, sending their yields lower in conjunction. The yield of the 10-year currently stands at 4.20%, compared with 4.39% two weeks ago. The yield of the two-year note also has fallen.

The problem for banks is that short-term yields will continue rising at a regular pace, as the Fed appears poised to continue lifting its key rate to at least 4% by year-end. At the same time, the yield of the 10-year bond seems like it will stay low, reflecting low inflation expectations and strong foreign demand for the bond.

According to the Bond Market Association, Wall Street banks on average expect the spread between the two-year and the 10-year yield to narrow to 0.15% by the end of the year.

Not all banks were created equal, of course. A bank that is more asset-sensitive (through its loans and securities) than liability-sensitive (through deposits and borrowings) will tend to fare better in an environment of short-term rising interest rates, according to Lehman Brothers analyst Jason Goldberg.

Assets and liabilities tend to shift constantly, but at the end of the second quarter, Goldberg found that among the most asset-sensitive banks were

Comerica

(CMA) - Get Report

,

Mellon Financial

(MEL)

, and

PNC Bank

(PNC) - Get Report

. Among the most liability-sensitive banks were Bank of America, Citigroup and

J.P. Morgan

(JPM) - Get Report

.

Not coincidentally, perhaps, the shares of asset-sensitive banks have outperformed those of liability-sensitive ones over the past three months.

For financial stocks overall, as for the broader market, much will depend on when the Fed ends its rate-tightening campaign. But there's something that worries J.P. Morgan strategist Abhijit Chakrabortti about the sector in the short term, especially after the mini-bond rally that has led all financials to rise.

"Financials appear vulnerable to earnings risk, as consensus expectations call for 25% earnings growth for the third quarter, a forecast we view as highly optimistic," he wrote in a research note.

Indeed, according to Thomson Financial, the ratio of negative-to-positive earnings preannouncements for the third quarter for financial companies in the S&P 500 is at 4.3, much higher than the average 2.2 ratio for all sectors in the S&P.

As originally published, this story contained an error. Please see

Corrections and Clarifications.

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

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