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Foreclosure mess to test stocks' rally

By Edward Krudy

NEW YORK (Reuters) - U.S. banks will be in the limelight this week as several household names report earnings and investors worry a forced halt to foreclosure proceedings could hit the sector and end the recent rally.

Bank shares fell sharply on Friday on very high volume, continuing a slide from the previous day. Although recovering some of their losses, Bank of America <BAC.N> shares hit their lowest in more than a year, while the KBW bank index .BKX> fell 2.4 percent.

Shares of Bank of America, the nation's largest mortgage lender, fell 9 percent during the week. More than 595.9 million of its shares traded on Friday, the most since April 2009 and over four times the 50-day moving average.

Investors worry banks did not follow proper due diligence when foreclosing on homes whose owners were not making mortgage payments, which could result in costly litigation, fines and additional mortgage repurchases.

Kevin Caron, market strategist at Stifel, Nicolaus & Co in Florham Park, New Jersey, said that situation could also weigh on the housing market if the uncertainty discouraged buyers from entering into contracts on properties under foreclosure.

"That speculative investor on the margin may choose to not to engage in that activity, which means there's the potential that you could have some weakness in demand, particularly in the lower-end speculative range of the housing market," he said.

BANK EXECS ON FIRING LINE

Investors will pepper bank executives with questions when those companies present earnings reports this week. Banks reporting results include Wells Fargo <WFC.N>, Bank of America, and Citigroup Inc <C.N>, three of the largest mortgage lenders in the nation.

The broad S&P financial sector is expected to show earnings of $27.7 billion in the third quarter, a 71 percent increase over a year earlier, although third-quarter revenue growth is seen falling 6 percent to $252.9 billion.

However, earnings estimates have been cut on some banks. Financials with the biggest reductions in earnings estimates for the quarter in the latest week are Goldman Sachs <GS.N>, PNC Financial <PNC.N>, and Citigroup, according to John Butters, director of U.S. earnings at Thomson Reuters.

The financial sector has been a conundrum in the latest market rally since the start of September. The KBW index <.BKX>has gained only 4 percent at a time when the broader S&P 500 has rallied nearly 12 percent.

David Giroux, who runs T. Rowe Price's $9.4 billion Capital Appreciation Fund, said expectations that deflation would weigh on bank earnings in the near term was pressuring the sector. He said banks were now attractively valued and the sector is the fund's largest, making up nearly 15 percent of assets.

"Most of the large banks are asset sensitive, which means that as rates rise, their profits should rise," he said. "So if you're a big believer in deflation, which the market has become a big believer in ... financials do poorly."

Giroux said a second round of stimulus from the Federal Reserve was unnecessary as inflation was already present in the system. Hopes the Fed will pump billions into the economy have helped drive stocks higher recently.

The Fed will release its Beige Book during the week and that will provide another insight into the central bank's thinking on the economy. On Friday, Fed Chairman Ben Bernanke hinted more monetary stimulus was on the way.

SLEW OF EARNINGS ON TAP

A number of other big U.S. companies from a range of industries will also present their scorecards this week, giving investors more clues about the economy's health. They include Apple Inc <AAPL.O>, Caterpillar Inc <CAT.N> and Johnson & Johnson <JNJ.N>.

Early indications from this earnings season have been mixed. Google Inc <GOOG.O> blew past analysts' expectations on Friday, driving its stock up 11.2 percent, while lower-than- expected revenue at General Electric <GE.N>, often seen as a proxy for the economy, pushed its shares down 5.1 percent.

Signs in the options market suggest more volatility this week as the recent trend of a continuous slide in the volatility index seems to be coming to an end.

"There is more call buying on the VIX now than put selling, which suggests that traders see a spike in VIX in the near term," said Randy Frederick, director of trading and derivatives at the Schwab Center for Financial Research in Austin, Texas.

The Chicago Board Options Exchange Volatility Index, or VIX, closed on Friday at 19.03, down 4.3 percent, after rising above 21 during the day.

The market has continued to move higher since the S&P 500 broke a resistance level at around 1,130 in the middle of September. Some chartists are now looking at an upside target of 1,228.74, the 61.8 percent Fibonacci retracement from the 2007 high.

This week may also see a so-called "golden cross" in the S&P 500 if the 50-day moving average rises above the 200-day -- a bullish sign for some traders. The 14-day moving average moved above the 50-day and the 200-day averages in September.

Industrial production data will kick off the week, followed by Tuesday's report on September housing starts. A weak housing number could rattle investors at a time when they're already anxious about the housing sector. Housing starts are seen slipping to an annualized rate of 580,000 units, according to economists polled by Reuters.

Elsewhere on the economic front, the Philly Fed index is among early indicators of October regional business activity leading up to the national surveys on manufacturing and services from the Institute for Supply Management at the end of the month.

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