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Breakout: These stocks may be ready to run

Traders work on the floor of the New York Stock Exchange.
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Traders work on the floor of the New York Stock Exchange.

Big financials have been perking up lately and may be ready for an even greater run higher.

The financial sector was the top-performing major S&P category last week, up 1.6 percent. While the stocks are flattish Monday, traders see more interest in the group as a whole. For May so far, the group is up 2.5 percent, though they are basically flat for the year.

"It's a kind of rotation. Banks have been underperforming the market for so long, and their earnings continue to rise. All of a sudden, the valuations on the stocks are very, very low relative to other stocks in the market," said Richard Bove, bank analyst at Rafferty Capital.

Traders said the Street is not underweight the group but they have been underinvested relative to other sectors that are looking overbought. There was also interest around the group as Treasury yields have been rising in recent sessions, signaling to some that other rates could follow.

Bove, however, said he doesn't expect a Fed rate hike anytime soon but sees other factors helping the sector. He said a jump in mergers and acquisitions activity and more active trading has been a boost to major firms like JPMorgan Chase, Bank of America, Citigroup, Wells Fargo, Morgan Stanley and Goldman Sachs.

"The currency war has been a gift from the gods to the banks," said Bove. "Currencies are going crazy all over the place. That's what you're look for. You're looking for action in currencies, energy commodities. You're getting it in equities. You're getting it in swinging Treasury rates," he said.

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Bove said it's the biggest of the banks and investment banks that should do the best. "There is a significant difference in their businesses which was discovered in the first-quarter earnings reports. Those companies, unlike the majority of companies in the industry, are all of sudden in a number of businesses that are exciting again," he said.

Deutsche Bank, in a note Monday, pointed out that the net margins on financial companies' profits rose in the first quarter to 17 percent from 14.9 percent a year ago, while overall S&P 500 margins were at 10.5 percent, from 10.3 percent a year ago.

Deutsche Bank analysts said fewer litigation charges at JPMorgan, Citigroup and Bank of America were a contributor to higher margins but even without those three institutions, financial net margins were at 16.6 percent.

"We think banks are a better hedge against inflation than energy," said the Deutsche analysts. They also prefer the big banks and capital markets firms.

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Bove said investors are looking at bank profit growth, against their lower-than-average market multiples. "Banks are having a hard time trading at 1.3 to 1.5 times book ... in the past they've been as high as two times book. The book value keeps going up, earnings keep going up and the stocks keep going down, and that doesn't make sense in the market going forward," he said.

As for smaller banks, they are waiting for an improving economy. "The regionals are in decent condition. The regionals need two things to show decent earnings. They need an increase in interest rates, and they need a better economy," Bove said. "There's nothing exciting going on there except valuations are low relative to the overall market."

Bove said there is a risk for the major banks, and it's not insignificant. As U.S. regulators turned their attention to foreign banks, foreign regulators have set their sights on U.S. institutions, and the risk is now greater from abroad.

Standard & Poor's covers 180 financial stocks but has "strong buy" recommendations on just 11 names in the sector and "buy" ratings on 68. The stocks S&P analysts say have the most potential to gain include Morgan Stanley, Everest Re, Huntington Bancshares and Synovus Financial.

"I would not say overweight the group but I would say that there are some financials we favor," said Sam Stovall, chief equity strategist at S&P Capital IQ.

Others rated "strong buy" by S&P include Lazard Ltd, Berkshire Hathaway B, Blackstone Group, KKR & Co., UBS Group, ING Group and Capital One.

"I think they're going to respond favorably to the prospect the Fed is going to raise rates in September or later," rather than sooner, said Stovall. "A rising tide lifts all boats so financials could end up doing relatively well."

Stovall said he looked back 60 years at the response of bank stocks to rate hikes, and found the reaction is not quite as expected.

"As short-term rates rise, the yield spread narrows which means it's harder for banks that earn their income on net interest margins. They end up seeing those margins get squeezed," he said.

Traders have been watching the trading in banks for the last several days to see if the renewed interest by investors' lasts, and also whether it might be a message about the broader market.

"When financials are outperforming, the broader index is much more likely to rally," said UBS strategist Julian Emanuel recently. "We'll be watching that very closely."

Traders playing the sector are watching the XLF Financial Select Sector SPDR Fund and KRE SPDR S&P Regional Banking ETF, among others.