The Lull in the Banks’ Storm

As expected, stocks are charging higher since Wednesday following weeks of protracted selling. That’s not a surprise. My blog yesterday detailed why a big rally was imminent as the VIX was heavily overbought.

A dose of good news finally arrived yesterday following Wells Fargo’s (NYSE-WFC) Q2 earnings report. A day earlier, State Street Bank (NYSE-STT) also delivered better than expected numbers.

The result, of course, is an incredible rally for financials. Heading into Wednesday’s trading the financials were down more than 55% from their highs last summer. Since financials also represent the largest index weightings for international indices, it’s no wonder foreign markets are also running hard along with Wall Street.

On Wednesday, bank stocks posted their best single-day rally since 1989, gaining more than 17%. More of the same is expected today following J.P. Morgan’s numbers.

With the exception of State Street’s numbers, which were mostly organic profits, Wells Fargo’s numbers don’t exactly elicit anything to celebrate about.

Wall Street’s relieved because Wells reported better than expected numbers. The bank also raised its dividend by 10%. That’s where the good news comes to an end.

Wells Fargo’s provision for loan losses more than quadrupled while half of the quarter’s $3 billion in loan-loss provisions went to build credit reserves. Worse, net charge-offs equaled 1.55% of total loans compared with 0.87% of total loans 12 months earlier.

I’m not sure those numbers are worth uncorking a bottle of Champagne.

J.P. Morgan is also reporting large loan-losses for the second quarter, yet the stock is rallying in pre-market trading. Its CEO, Jimmy Dimon, is also warnings of increasingly “difficult financial market conditions” for the remainder of the year.

From where I see it, these results are a harbinger of worse things to come. There’s absolutely no reason to buy this sector. All we’re seeing now is a dead-cat bounce following weeks of relentless financial sector pounding.

The subprime debacle has now largely been written off by most American, Canadian and European banks. But what lies ahead is worse. Consumer loans are now coming undone. Banks are witnessing a significant rise in delinquencies, which I expect to rise dramatically as the economy and employment trends worsen over the next several months.

In a bear market, a dead-cat bounce is typical market action following weeks of pervasive selling. More banks will fail this year, more write-downs will occur and the Fed can’t reduce interest rates any further because of the highest inflation in 15 years.

Sell into market strength.

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