Stocks Rally, Led by Financials

Indexes overcame initial jitters as crude dropped sharply and Bernanke and Paulson expressed optimism

A triple helping of speeches from government and private-sector bigwigs elicited a stock market rally on Tuesday, something a drop in oil prices alone wasn't able to do a day earlier.

Major U.S. stock indexes finished higher on Tuesday after a volatile session that had investors looking for direction amid mostly optimistic comments from Federal Reserve Chairman Ben Bernanke, Treasury Secretary Henry Paulson and JPMorgan Chase Chief Executive Jamie Dimon, all expressing confidence that the housing and credit crises will eventually pass, but not before many more months of pain.

Financial issues staged a rare rally, with the S&P Thrifts & Mortgage Finance index rising 9.7%

and the S&P Regional Banks index climbing 7.9%.

A decline in oil prices for a second consecutive day to the mid-$130s range, along with weakness in other commodities, also helped drive investors back toward equities.

On Tuesday, the Dow Jones Industrial Average ended 152.25 points, or 1.36%, higher at 11,384.21. The broader S&P 500 edged gained 21.38 points, or 1.71%, to close at 1,273.69. The tech-heavy Nasdaq composite index jumped 51.12 points, or 2.28%, to 2,294.44.

On the New York Stock Exchange, 21 stocks traded higher for every 10 on the skids, while on the Nasdaq, the ratio was 20-8 positive.

The $10 drop in oil prices from record highs approaching $146 a barrel on July 3 helped to improve the profit outlook for transport and retail companies, while the financial stocks got a lift from Bernanke, who said in a speech at the FDIC forum that the central bank might extend the duration of the emergency loan program that's helped Wall Street firms weather the financial crisis beyond the end of this year.

While a few commentators were seeing signs of the nine-month correction in equities nearing an end, Joe Battipaglia, market strategist at Stifel Nicolaus in Philadelphia, says he sees nothing more than "an ongoing rotation from one group to another, with no sense of overall conviction" amid too many calls on market bottoms since January.

Although the market has run with all prior confidence statements from the Fed or Treasury Department for very short periods of time, the rallies have all collapsed when there’s no follow through, says Battipaglia. All the prescriptive talk of policy initiatives won't correct the decline in earnings that many companies are currently experiencing, he adds.

He expects an additional 5% to 10% downside risk in stock prices and says that analysts need to cut their earnings estimates for the rest of 2008 and 2009. He projects average earnings growth in the low single digits in the third and fourth quarters of this year instead of the 50% gains that some analysts have forecast.

He thinks it's reasonable to assume that weighted average earnings for the S&P 500 index, including the financial stocks, will be around $80 a share for 2008, while the market is currently estimating something closer to the mid $90 range. Market valuations will be constrained by reduced earnings forecasts, he adds.

In his speech at the FDIC forum, Treasury Secretary Paulson said that while he expects there to be many more foreclosures before the housing slump ends, the 21.6% decline in inventories of new single-family homes since the 2006 peak shows the housing market is well into an adjustment period. He also urged legislators to speed up efforts on a reform bill governing the activities of government-sponsored enterprises Fannie Mae (FNM) and Freddie Mac (FRE) and recommended more thorough collateralization of mortgage bonds.

Fannie and Freddie, which earlier in the day had extended their slides from Monday, rebounded on Paulson's remarks, where earlier words of encouragement from James Lockhart, director of the Office of Federal Housing Enterprise Oversight, the GSEs' regulator, had failed to convince investors. Lockhart, in a CNBC interview, said that "an accounting change shouldn't drive a capital change"

if the FASB 140 rule is applied to Fannie and Freddie and forces them to bring off-balance-sheet assets on to their books.

Lockhart said that the OFHEO is working with the accounting board and agencies, which have raised over $20 billion and are adequately capitalized. This appears to lend some credence to the view that the government wouldn't shoot itself in the foot and force the government-sponsored enterprises, or GSEs, to provision further, while at the same time pushing for them to continue to expand mortgage lending into jumbo loans, said Action Economics. But Lockhart also reiterated his long-held view that the GSEs need to be closely supervised to continue to promote management improvements.

The market seemed to shrug off comments from Richmond Fed President Jeffrey Lacker, a well known hawk, in which he said it makes sense to start raising interest rates as growth risks fade, as the Fed needs to keep on top of risks associated with persistent high inflation. He said he doesn't see a risk of recession in the recent economic data and noted that consumer spending has been supported by the tax rebates, while the weak dollar has helped exports. Still, he said he sees a very slow recovery in housing, which may not have hit bottom.

In the most straightforward remarks made at the FDIC forum, JPMorgan's Dimon said he supports the Fed's blueprint for reform of banking regulations but was vague about how long it would take before investors start to buy securitized products such as mortgage-backed securities again. The two big uncertainties that will determine how soon financial markets return to normal are how much more housing prices will fall and how bad a recession will get, he said.

Bill Stone, chief investment strategist at PNC Wealth Management in Philadelphia, says he isn't giving Bernanke's or Paulson's comments a lot of weight since nobody really knows when housing or credit market conditions will stabilize. But he does believe that stocks are worth more than they’re being given credit for and thinks investors who are underweight certain sectors would do well to nibble at beaten-down stocks here and there and regard it as dollar-cost averaging against higher prices they may have paid for these names in the recent past.

Leading this week's trickle of fresh economic data, U.S. wholesale trade sales jumped 1.6% in May, more than the average forecast of a 1.0% increase. U.S. wholesale inventories rose 0.8% in May, slightly lower than anticipated. There is significant upside risk on the month from petroleum prices. The data bode well for the inventory contribution to second-quarter Gross Domestic Product, which Action Economics expects to grow at 2.2% with a projected $10 billion decline in inventories.

The National Association of Realtors' pending home sales index dropped 4.7% to 84.7 in May after a 6.3% surge to 88.9 in April, which was the biggest monthly increase since December, 2001, and left the index at the best level since last October. Though the housing market is not out of the woods, another reading above the March low of 83.0 is encouraging despite the pullback in May, Action Economics said.

August WTI crude oil futures dropped $5.38 to settle at $136.04 a barrel on Tuesday as the dollar continued to gain strength and amid a broader selloff in commodities on concerns that worldwide economic slowing would continue to erode demand for oil and other fuels. The U.S. Energy Information Administration said Tuesday it now expects U.S. oil usage to be down 400,000 barrels a day in 2008 rather than the 300,000 barrel-a-day decline it previously projected. The EIA also said it sees WTI crude price averaging $127.39 a barrel this year. U.S. gasoline demand continues to fall due to prices above $4.00 per gallon.

August gold futures were off $5.50 at $923.30 per ounce Tuesday.

Among other stocks in the news on Tuesday, Office Depot (ODP) shares fell sharply after the company reported a nearly 10% drop in North American retail same-store sales due to additional pressure from weakening business conditions in the second quarter, while total company sales were down slightly. Office Depot expects its second-quarter margin on earnings before interest and taxes to have fallen by more than the 2.0% to 2.5% previously indicated on year over year basis as sales trends worsened late in the quarter. Standard & Poor's maintained its hold rating on the stock.

InterDigital Inc. (IDCC) shares plummeted after the digital wireless technology designer said the U.S. International Trade Commission has recommended against concluding that Samsung Electronics violated certain trade rules by importing patented mobile handsets and components. The company noted the ITC staff's recommendation is not binding for the judge overseeing the investigation, for which evidentiary hearings began Tuesday.

Century Aluminum Co. (CENX) shares plunged on news of a deal with Glencore to unwind all of Century's primary aluminum financial forward sales contracts. The contracts have been settled for a total value of $978.4 million in a new class of non-voting convertible preferred stock, plus $730.2 million in cash. Century will offer 6.5 million shares.

Goodrich Petroleum (GDP) shares dropped after the company announced that it has commenced an underwritten public offering of 3.0 million shares.

Major European indexes were trading lower Tuesday. In London, the FTSE 100 index slid 1.31% to 5,440.50. In Paris, the CAC 40 fell 1.54% to 4,275.61, while Germany's DAX index was off 1.43% at 6,304.41.

In Asia, Japan's Nikkei 225 finished 2.45% lower at 13,033.10, and Hong Kong's Hang Seng index sank 3.16% to end at 21,220.81.

Treasury market

Treasury prices climbed despite the stock rally. The 2-year Treasury note was down 02/32 at 100-24/32 for a yield of 2.48%, while the 10-year note moved up 05/32 to 99-29/32 for a yield of 3.88%, and the 30-year note rose 17/32 to 98-24/32 for a yield of 4.45%.

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