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Surprise: Bank stocks suddenly are leading the market

Trading banks ahead of earnings: 8 plays

Amid a sluggish month for the stock market overall, banks have been an unexpected bright spot.

Stocks as measured by the are negative for October, down about 1.5 percent heading into Wednesday trading. Lackluster economic reports, uncertainty in monetary policy and a bruising homestretch in the presidential campaign have helped keep equities in check.

After a tough year, though, banks are now outperforming.

The KBW Nasdaq Bank Index has gained a healthy 2.6 percent for the month and was outperforming the S&P 500 in early trading Wednesday. That comes amid a difficult year for the industry and big banks in particular, with the KBW index down 1 percent for the year against a 4.4 percent gain for the S&P 500.

Not much has changed fundamentally for banks. They still face increased regulatory pressure, and profitability has been difficult amid a flat yield curve and a Fed that has been on hold with interest rate increases this year.

However, analyst Dick Bove believes an important shift is happening:

In 2016, it is evident that bank earnings will not keep pace with 2015 results. The economy is weighing heavily on their earnings outlooks. Yet the stocks are doing unusually well. What is being demonstrated here is that these stocks do not respond to earnings as much as they do to changing psychology."

It seems a hard argument to make — with Wells Fargo under the spotlight for illegal sales practices, and Deutsche Bank struggling under severe capital pressures — that the negative perception toward banks is changing.

But Bove, vice president of equity research at Rafferty Capital Markets, thinks that's exactly what's happening.

In 2015, fears concerning the impact of oil and a slowing economy caused the stock prices to weaken because these two events suggested that asset quality would weaken. It was also feared that interest rates would stay down. Thus, earnings results were ignored.

After the first quarter in 2016, the psychology changed. The oil price issue disappeared. Interest rates were in fact rising so no one cared that earnings growth had weakened. Thus, bank stock valuations started the returning to the mean.

Lacking any significant event that will cause issues to rise related to asset quality these stocks are expected to continue upward. Short term interest rates have paused for the moment but their trend is higher. Earnings do not matter but they are expected to be weak. Regional banks are still expected to lead the group.

Optimism for the banks comes at a good time. Quarterly earnings reports for the biggest financial institutions start rolling in on Friday, so the recent rise could be in anticipation that the numbers won't be as bad as feared.

Individually, Bank of America and Citigroup led the gains among the biggest banks, while SunTrust, Regions Financial and KeyCorp have led the way among regionals in October.

Bove, though, continued to advocate that investors stay away from Wells Fargo. The second-largest U.S. bank is the only sell in Bove's coverage universe, and he reiterated that position this week.