Finance sector looks better, but don't bank on it

Caught in a typhoon of world finance, bank stocks and mutual funds have whipped around like a kite for weeks, pulling other equities along on a ripping ride.

Expect more tugging.

The sector should continue as a high-profile bellwether, both leading and exaggerating ups and downs in the overall market, say analysts.

Since mid-October, as financial turmoil has eased along with short-term interest rates, banks have traced a jagged line skyward. And analysts are optimistic, but cautious, about the future.

"The worst is over," says analyst Joseph Duwan at Keefe, Bruyette & Woods in New York.

"We're very optimistic but very selective," says Fred Cummings of McDonald & Co. in New York. "We still think there are some good values, and we expect the stocks could approach their 52-week highs within the next nine months."

Much of that optimism depends on whether the Federal Reserve cuts interest rates again.

Banks handle credit, the force that acts both as oil and gasoline to an economy and keeps businesses running smooth and strong. So an economy's fillip or fizzle often hits banks first.

In recent years the sector led the stock market upward. But in July, that leadership reversed course into a nose dive as:

* Russia in August defaulted on foreign debts and devalued the ruble. US and European banks - already pinched by losses in East Asia - with loans to Russia were hurt badly.

* Bumbling by Tokyo over more than $1 trillion in bad bank debt provoked concern an East Asian credit crunch could spread stateside.

* Anxiety peaked when Long-Term Capital Management, the huge hedge fund, nearly collapsed, threatening serious damage to some prominent banks. The fund seems back on track after a $3.6 billion dollar bailout.

"The hedge fund blow-up was quite alarming," says Mr. Cummings. "A lot of investors and analysts were saying, 'Where else could we have a situation where banks are badly exposed?' "

The turmoil hammered third-quarter profits at some of the biggest banking names in the US.

Bankers Trust lost $488 million; profits plunged 61 percent for J.P. Morgan and 78 percent at BankAmerica.

The numbers spooked investors and prompted a classic sell-off. As credit concerns ebbed, though, investors swooped back in on some eye-popping bargains.

"This does not appear to be the greatest crisis in global economics in 50 years as some leaders say," says James Shutz, an analyst with ABN Amro in Chicago.

Still, analysts caution investors to stay away from mortgage banks and the big, money-center banks - such as BankAmerica and J.P. Morgan - that have been active in foreign lending. Such loans could be a liability if foreign turmoil stages a return.

Banks that focus on US consumers and businesses, by contrast, look most attractive.

Mortgage refinancing has probably peaked, making for slower growth in that sector. Regional banks offer the most promise, analysts say. The top regional-bank mutual funds ranked by Morningstar for three-year, annualized returns are Fidelity Select Regional Bank, up 28.9 percent a year, and John Hancock Regional Bank A, up 26.5 percent annually.

And analysts still see bargains among specific regional banks despite the recent market recovery. Analysts like Bank One, First Union, Fleet Financial, and Mellon Bank.

But hold on tight. "No question, it will be quite bumpy as credit concerns persist," says analyst David Stumpf at A.G. Edwards in St. Louis.

Since bank-stock investors do not expect a downturn in the economy, he says, the prices of bank stocks will likely fall if a surprise recession overtakes the broad economy.