Financial stocks have rallied significantly since November.  A perceived reduction in risk in this sector has improved the overall stock market tone and has produced a decline in volatility.  A major factor behind this shift has been altered perceptions on European credit conditions.  The underlying fundamentals for the U.S. banking sector have also improved, however, as lending has increased. 

The Recent Improvement in Financial Sector Stocks

The chart below shows the financial exchange traded fund (symbol XLF) over the past year.  This exchange traded fund includes traditional banks as well as companies such as Goldman Sachs and Morgan Stanley (list of components http://etfinvestmentoutlook.com/etf_holdings.php?s=XLF).

As can be seen, the financial sector declined the first nine months of 2011.  The weakness in financial stocks was a major reason the overall S&P 500 index was flat in 2011 despite an increase in total S&P 500 earnings in 2011.   And the reason these stocks were pressured was persistent concerns about the credit problems in Europe.

The sector stabilized in a choppy manner in October and November, and then rallied steadily in December, January, and early February.

It is not a coincidence that the overall market has not only risen but has been far less volatile the past two months.  The uptrend in financial sector stocks has significantly improved the overall market tone.

A Quick Review

The crash of 2008 was credit based.  The bubble and subsequent crash in the housing market was a root cause of the ultimate economic problems, but not the factor that produced "the great recession."

The extended weakness in the economy was caused by the implosion in the credit markets.  There were far too many leveraged derivative credit products that produced extensive interconnections between financial companies that led to magnified losses and an immediate freeze-up in the credit markets. 

A vicious self-reinforcing, downward spiral pushed credit market securities prices down, which required banks to stop lending and to build capital, which included selling credit securities, which pushed stock prices down, which pushed credit securities prices down further, etc. 

The credit markets -- the lifeblood of modern economies -- became dysfunctional.

This was not a problem that could be solved in the short term.  It takes time for the credit markets to heal.  It takes time for lending to resume.  It takes years. 

A Pickup in Lending

The weekly H.8 release from the Federal Reserve provides weekly data on loans from commercial banks.  It is a release that deserves more attention than it receives.  It reflects the health of the credit markets. 

The data show that total bank credit, which includes loans as well as investment in government securities, fell sharply in 2009 and 2010.  Bank credit then began to rebound in 2011, posting a small increase for the year as a whole, but rising at a solid 6.5% annual rate in the second half of the year.  The growth has continued into 2012.

Annual Rate Percent Change

The foundation of this turnaround in bank credit has been the growth in commercial and industrial (C&I) loans.

C&I loans are critical to business growth, and thus overall economic growth.  The trends reflect banks' willingness to lend as well as demand from business.

The chart below shows just how sharply C&I loans have picked up after plunging in 2009 and 2010.

In December, C&I loans rose at a 12.5% annual rate, and the growth continued at an 11% annual rate in January.

This very encouraging trend in C&I loans has recently been augmented by surprising stabilization in real estate loans.

Overall real estate loans were down in 2008, 2009, 2010, and 2011.

Yet, there may be good news developing.

Seasonally adjusted, billions of dollars

As can be seen, real estate loans outstanding turned significantly higher in January.  The week ended February 1, such loans outstanding were $3,517 bln.  That is the highest level since April 2011.

It is too early to declare victory and to suggest that real estate loans will now rise steadily, but the recent trends are extremely encouraging.

Real estate lending might have finally turned the corner.

The Importance of Bank Loans

Credit is the lifeblood of the modern economy.  The breakdown and implosion of the credit markets was the major factor behind the severity of the economic downturn of 2008 and the key reason the recovery has been so sluggish.

Rebounds from inventory recessions are sharp and strong.  Recoveries from interest rate-induced recessions, such as those of the early 1980s, are also relatively rapid.  The same is true from recessions caused by consumer spending or trade swings.

Damage to the credit markets and credit creation, however, takes a long time to repair.  It takes time for banks to repair damaged balance sheets and to write off bad loans.  It takes time for lenders to become comfortable extending credit again in difficult economic times.  It takes time for borrowers to become comfortable taking on credit (as exemplified by the unwillingness of potential home buyers to take on mortgages despite low rates and low home prices).

Time, however, happens.

It has been over three years since the collapse of October 2008.  The data show that banks started expanding credit to businesses last year.  There are signs that credit to the real estate sector is also now expanding.

These are extremely good signs for the economy.  Expanding credit is critical to returning economic growth to long-term trends.

What It All Means

There are always risks in the financial markets.  There are risks in the credit outlook.  European credit markets could implode, with a ripple effect damaging U.S. credit markets and credit expansion.  Damage to banks would be significant.

Yet, time appears to be allowing the credit markets to adjust to the problems in Europe.  U.S. banks have had time to reduce risk associated with possible European government defaults.  European governments have had time to build backup facilities to smooth the workings of the credit markets. 

This is in stark contrast to the speed with which the U.S. credit markets imploded following the Lehman bankruptcy.

If U.S. banks have been able to reduce the risk associated with possible European credit disruptions, the downside risk for U.S. financial sector stocks is significantly reduced.  That would reduce volatility for the overall market in 2012 compared to recent years.

At the same time, credit conditions in the U.S. are clearly improving.  Lending is picking up.  That will increase earnings for banks and produce upside potential for U.S. financial stocks. 

A stable or stronger banking sector and an uptrend in financial stocks could provide significant support to the U.S. economy and stock market in 2012.

These could be early signs that the end of the "great recession" is approaching.

--Dick Green, Briefing.com