US stocks rallied strongly, taking the S&P to a three-month high on Wednesday, as optimism from the Federal Reserve on the economy added to renewed confidence over banks’ balance sheets.

Shares gained as the Fed said the contraction in the economy “appears to be somewhat slower”, and held off from ramping up quantitative easing.

Analysts said the stability of Fed policies bolstered confidence in the economy. “Any time your doctor isn’t concerned when he looks at the test you feel reassured,” said Bruce McCain, chief investment strategist for Key Private Bank.

This helped overcome advance figures showing the US economy shrank more than expected during the first quarter of 2009.

Banking stocks led the financial sector higher, after analysis from Fox-Pitt Kelton said that it thought the results of the government’s stress tests would not be as bad as expected and that any possible shareholder dilution was already built into stock prices. Citigroup rose 8 per cent to $3.12 on the analysis.

Bank of America, the other leading banking group reported to require more capital after the test results, also rose after Fox-Pitt’s analysis. The bank’s shares gained 6.5 per cent to $8.68 in spite of the fate of Ken Lewis’ role as both chairman and chief executive hanging in the balance after a vote among shareholders.

Regional banks involved in the stress test also performed strongly, with Keycorp gaining 3.1 per cent to $6.26 and Fifth Third jumping 11.6 per cent to $4.13.

The upgrade by Fox-Pitt helped the banking sector overcome concerns over revenues from mortgage refinancing, as figures showed that the number of home loan applications dropped significantly last week. It also mitigated the effect of a Bloomberg report that said six of the 19 banks “stress tested” by the government needed more capital.

“People are seeing the Bloomberg report as a positive, as it adds clarity to banks’ capital positions,” said Alan Ruskin, strategist at RBS.

Investors also looked beyond a sharper contraction in the US economy than analysts had predicted, and took confidence from an unexpectedly strong rise in personal consumption.

The benchmark S&P 500 index closed 2.2 per cent up at 873.64 points, a level not seen since January 9, while the Dow Jones Industrial Average gained 2.1 per cent to 8,185.73 points and the Nasdaq Composite index climbed 2.3 per cent to 1,711.94 points.

Several companies reported better earnings than predicted.

Time Warner, the media group, said it might spin off one or more parts of its AOL internet division after reporting a lower fall in profits than predicted. The company rose 1 per cent to $21.98 as analysts said shedding AOL could improve the company’s valuation.

Time Warner Cable, the company’s cable unit, which was split off from the main business, was able to add customers, however, and, having cut capital expenditure, was able to beat expectations with first-quarter profits. Its shares gained
14.2 per cent to $31.12.

Telecoms company Qwest was able to combat falling revenues and report better earnings than expected, excluding certain one-off items. Its shares climbed 3.1 per cent to $3.68.

Wyeth, the pharmaceutical company, also made better profits than expected, as cost cuts proved effective. Shares in the company, which has agreed to be bought by Pfizer, gained 0.8 per cent to $42.60.

Aetna weighed on the healthcare sector after it reported worse first-quarter profits than Wall Street had expected.

Costs remained high, taking their toll even as customers rose, and its shares fell 10.3 per cent to $21.88.

Dendreon jumped after it reported the results of tests on its experimental prostate cancer drug Provenge, which were good enough for Wachovia to upgrade the company to “outperform”.

Its shares dropped on Tuesday before trade was halted ahead of the results, but rebounded on Wednesday to the previous session’s highs. They closed on Wednesday 94.2 per cent up at $22.94.

“Stocks look pretty attractive, having hit highs for the latest bull run,” said John Brady, senior vice-president at MF Global. “The rally may continue as people buy stocks to cover their short positions.”

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