Morgan Stanley analysts Monday told clients to "sell the rally" in financial stocks, slashing forecasts for big bank earnings and warning that the current credit crunch is only just beginning.
In aggregate, Morgan Stanley reduced its estimates for 2008 large bank earnings by $17 billion, or 26 percent, and reduced 2009 forecasts by $13 billion, or 15 percent.
The analysts expect higher loan losses and expenses, offset by higher net interest income, though profits could fall further still if the Federal Reserve stops lowering interest rates.
"More capital hikes and dividend cuts (are) coming as our credit deteriorates and forward earnings decline," analysts led by Betsy Graseck wrote in a report.
"We think we are only in the third inning of the credit cycle and expect this credit cycle will be worse than (the slump in) 1990-91." A growing number of investors, and industry executives including Morgan Stanley Chief Executive John Mack, in recent weeks have predicted markets are closer to the end of the current mortgage and corporate credit crisis than to the beginning.
These more upbeat comments, and recent efforts by banks to bolster their balance sheets, helped spark a rebound in bank stocks last week.
Morgan Stanley's top "long" picks have less credit sensitivity or better capital structures: Bank of New York, JPMorgan Chase and PNC Financial Group.
By contrast, investors should "underweight" banks with greater exposure to mortgages -- Wells Fargo and Wachovia-- and those that operate in harder hit sections of the United States -- Fifth Third Bancorp and KeyCorp .
Morgan Stanley also called for underweighting Citigroup citing its exposure to risky assets relative to common equity.