Bank Stock Rally Faces Earnings Test

NEW YORK ( TheStreet) -- The performance of the big money-center banks in the first quarter will hinge upon whether they spent time boosting profits in booming areas, or stitching up wounds in still-troubled ones.

On the upside, last quarter saw a continuation of capital markets improvements. Wealth management, stock and bond issuance, advisory services and proprietary trading divisions all had growth potential during the first quarter. At the same time, net interest margins appear to have grown further, while credit costs -- while still elevated -- are expected to continue to abate.

On the downside, lending is weak and new regulation has curtailed fee revenue from traditional sources like overdrafts , credit cards , deposits and the like. It's unclear how mortgage workout programs are actually faring, while charge-offs and foreclosures are still running high. It's also difficult to tell how much the fees from strong refinancing volumes and new home purchases have helped to counter those losses. Yet banks that took advantage of the shifting interest rate environment early on with smart hedging strategies may have offset housing losses entirely.

Collins Stewart analyst Todd Hagerman issued a report on Monday, citing the positive trends for the group in his upgrade of Wells Fargo's ( WFC) stock to buy, and a reiteration of the same rating for JPMorgan Chase ( JPM) and Bank of America ( BAC). He rates Citigroup ( C) stock a hold.

"Bank stocks have soared this quarter as cheap valuations, combined with the likelihood that credit has finally reached an inflection point, have provided the necessary fuel to propel the group higher," Hagerman said in his report.

Deutsche Bank analyst Matt O'Connor also points out that negative elements are "known issues" and identifies several areas that have room for "potential positive surprises." Among them are higher margins due to low funding costs, mortgage revenue, sales of nonperforming loans and trading in FICC -- shorthand for fixed income, currency and commodities.

"In addition, we think more banks will talk about becoming profitable at some point this year," O'Connor predicts.

Of course, a lot also hinges on expectations too -- and the positive Wall Street sentiment on banks may end up leading to a rally that falls flat when they report. The KBW Bank Index soared 22% during the first quarter, with JPMorgan gaining 7%, Wells Fargo adding 15%, Bank of America climbing 15% and Citigroup soaring 22%.

This first week of the second quarter, they have continued to surge. Bank of America, for instance, has risen in every session this week, and has strung together five consecutive closes above $18, something the stock hasn't done since November 2008.

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