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Despite Big Rally in Stocks, Worries on Economy Linger

As one of the most dizzying bear market rallies in Wall Street history enters its second month, a nagging question faces investors: Is the stock market making real progress, or glossing over deeper problems in the economy that will start a new wave of losses?

Wall Street Trader
AP
Wall Street Trader

Stocks surged more than 3 percent Thursday as a major bank predicted record profits.The announcement by Wells Fargo, one of the nation’s largest consumer banks, kindled hopes that the financial system, which dragged the larger economy toward the brink, was now poised to lead the way out.

The Dow Jones industrial average gained 246 points and the broader Standard & Poor’s 500-stock index rose nearly 4 percent. The S.& P. 500 has now risen more than 25 percent since stocks bottomed out on March 9, one of its best runs since the Great Depression.

Signs have been accumulating that the economy, while a long way from recovery, may be bottoming. Credit markets, frozen at the height of the financial crisis, have thawed as the government shores up the financial system.

Some of the worst-hit housing markets are edging toward a turnaround as low interest rates reel in buyers.

On Thursday, Lawrence H. Summers, one of President Obama’s top economic advisers, declared the “free fall” in the economy was likely to end in the next few months.

But as investors abandon caution to snap up cheap bank stocks and riskier instruments, like junk bonds, to profit from the market’s earlier declines, skeptics are warning that the economy may face another leg down.

Companies continue to shed jobs and consumers are hunkering down in anticipation of a halting recovery. Most of the nation’s retailers on Thursday signaled that they expected to see a continued steep decline in sales as they waited for consumers to come out of hiding.

“I think this is all setting us up for a new low,” said Thomas J. Lee, the chief United States equity strategist at JPMorgan Chase, who predicted an 8 to 10 percent drop in stocks. “It’s not like I’m praying for it to happen, but it’s pretty much expected.”

Members of the Obama administration, once criticized for darkening the sense of economic gloom, have pointed out wisps of stability in corners of the economy as they try to build confidence in their agenda.

But Mr. Summers also acknowledged that it was unclear how strong and rapid any turnaround would be.

One of the biggest worries facing economists is what would happen if unemployment rose beyond expectations and unleashed another wave of spending contractions and lower corporate profits.

Even as major banks like Wells Fargo, Citigroup and Bank of America regain some profitability after devastating losses — buoyed in part by government efforts to breathe new life into the housing market — experts warn that companies reflecting other sectors of the economy will soon suffer a wave of sharper declines in earnings.

“There’s a migration of weakness,” said Nicholas Bohnsack, sector strategist at Strategas Research Partners. “What you’re now seeing is the nonfinancial segment really start to tail off.”

Company earnings for the first quarter of 2009 are expected to slump about 37 percent from last year, according to Thomson Reuters. Much of the decline will be borne by retailers, energy companies and businesses that make products like chemicals and building materials, analysts say.

And even though banks may report better earnings this quarter, they are hardly in the clear. As the recession deepens, banks will continue to rack up big losses tied to credit cards, corporate loans, and residential and commercial real estate.

Bigger questions remain about the depth of the banks’ losses.

Federal banking regulators are close to completing stress tests to get a handle on the industry’s trouble, with early results suggesting that a handful of banks may still need capital. But much of the outcome depends on the degree to which the economy worsens.

Also unclear is how changes to accounting rules that regulate how banks value assets may affect the appearance of their financial health.

For now, however, investors are setting aside those concerns and grasping good news with vigor.

Wells Fargo sent the stock market on a dizzying rally Thursday when it revealed that its mortgage applications surged to $190 billion in the first quarter, a sharp increase that would lead it to a record $3 billion profit for the period.

Like other big banks, Wells appears to have benefited from a surge in mortgage refinancing because of ultralow borrowing rates engineered by the government and an exodus of competitors.

Bank of America, JPMorgan Chase, PNC Financial and others have had similarly strong performances and are expected to post improved profitability when earnings reports are issued next week.

Rates on a 30-year fixed mortgage dropped to a record low of 4.61 percent after moves by the Federal Reserve to slash target interest rates to nearly zero and ease lending by buying $1 trillion in longer-term Treasury notes and mortgage-backed securities.

Mortgage applications have surged since December, according to the Mortgage Bankers Association.

The value of loans securitized by Fannie Mae and Freddie Mac increased to $144.9 billion last month, from $37.5 billion in January, according to Inside Mortgage Finance.

Gary Gordon, an analyst at Portales Partners, estimated that lenders were on pace to originate about $3 trillion in new mortgages, about the same level as at the height of the housing boom, and profit margins had doubled.

But Mr. Gordon cautioned the good times could be fleeting. “This can’t last forever,” he said.

Even Wells Fargo’s finance chief, Howard I. Atkins, was reluctant to declare victory.

He said that Wells had adequate reserves and was “very comfortable” it had taken appropriate write-offs on the big portfolio of toxic mortgages and commercial real estate loans it accumulated when it took over Wachovia.

But he did not rule out taking more write-offs in the future.

“If the economy worsens significantly, we will have to revisit that,” Mr. Atkins said. “If the economy goes the other way, we may get something back.”