Bank stocks catch fire

November 5, 2010, 7:31 PM UTC

Bank stocks are back, and in a big way.

Shares of the biggest lenders surged Friday, as investors cheered signs that the economy isn’t on its death bed and that regulators may soon allow healthy banks to resume dividend payments.

Bouncing back

Bank of America and JPMorgan Chase each jumped 4%, and the KBW index of regional bank shares gained 6% (see chart, right), reflecting big rallies in smaller lenders.

The buying action reflects an uptick in the economy, which going by Friday’s jobs report may not be quite as ill as has widely been assumed.

“Today’s employment report shows the economy is not nearly as weak as initially advertised,” writes Bank of America Merrill Lynch economist Ethan Harris.

Also improving is the market’s view on the banks’ prospects for dealing with the mortgage mess, and their hopes of regaining some latitude to pay dividends and buy back shares, thereby drawing in new investors.

Shares of the biggest banks have been hard hit over the past year, as Wall Street has grappled with the price to be paid for tighter regulation and a never-ending season of reputation-eroding scandals.

But bulls on the bank stocks say those threats have been vastly overstated, causing the wary to miss out on the good news contained in what generally was a positive earnings season.

“These stocks were grossly oversold,” said Gary Townsend, who helps run Hill-Townsend Capital in Bethesda, Md., which owns Bank of America stock and JPMorgan warrants. “This is partly just a bounce off absurdly low levels.”

Townsend, who says his firm is “very long the banks group,” believes negative headlines from the foreclosure fiasco won’t translate into huge financial obligations for the big mortgage servicers such as BofA, JPMorgan and Wells Fargo .

Meanwhile, credit trends continue to slowly improve, and Townsend says he expects that to continue assuming the economy slowly picks up the recovery pace over the next year.

What he sketches out is hardly a sure thing, even with bank stocks trading at what Townsend calls valuations that are “far below historical standards.” Perhaps accordingly, much of the headiest action Friday has been in the banks’ warrants, which give the holder the right but not the obligation to buy the stock at a set price within a specified period.

Warrants are essentially a way to bet on a stock’s appreciation, without paying full price for the stock itself.

Among the biggest gainers Friday were warrants on Bank of America and PNC , each of which soared 11%, while those to buy Wells Fargo jumped 8%.