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Bank stocks are the favorite way on Wall Street to play a year-end market melt-up

  • Stronger economic prospects, higher interest rates and lowered regulatory barriers on the horizon have caused analysts at Bernstein and CFRA to upgrade financials.
  • Thanks to a big rally since mid-September, financials overall have caught up to market performance, though banks specifically still lag.
  • Tax reform, assuming Congress passes a measure similar to the proposals being bandied about, also is expected to boost the sector.
Bank of America Corp. ATMs outside of the Bank of America Plaza tower in Los Angeles, California.
Patrick T. Fallon | Bloomberg | Getty Images

Financial stocks were supposed to be one of the big winners in 2017, but instead ended up badly lagging the market for most of the year. Analysts, though, are willing to give the sector another shot heading into 2018.

With stronger economic prospects, higher interest rates and lowered regulatory barriers on the horizon, at least two analysts are telling clients to up their allocations to banks and other parts of the group. They also cite tax reform and additional consumer strength as reasons to be bullish.

The recommendations come as financials lately have caught fire. Thanks to a 15 percent rally since early September, the Financial Select Sector SPDR exchange-traded fund is now up 18 percent for the year, about in line with the S&P 500.

Even with the strong rally, Bernstein analyst Noah Weisberger said this is "a cycle with room to run." The firm has upgraded financials to overweight, a view shared by analysts at CFRA.

"Net-net, we believe a rising rate environment, firm economic backdrop, deregulation, upside from tax reform, underappreciated earnings growth and impending CapEx impulse bode well for financials," Weisberger said in a note to clients.

Though strong, the autumn rally in financials has been uneven.

Banks, as gauged by the SPDR S&P Bank ETF, are up only about half as much as the broader financial sector, though they've rallied nearly 20 percent since the same early September starting point. Insurers, per the SPDR S&P Insurance ETF, have gained nearly 13 percent for the year. By contrast, financial services, using the iShares U.S. Financial Services ETF, have outperformed both the sector and the market, with a gain of just over 20 percent for 2017.

Weisberger turned clients' attention to the consumer finance, regional banking and diversified banking spaces as those standing to benefit the most from the conditions ahead.

"Despite the recent rally, we still see pockets of opportunity, particularly in the context of a persistently strong economic backdrop," he wrote. "And from a fundamental perspective, we note price returns have not been commensurate with earnings growth revisions in certain sectors, even amidst generally reasonable valuations."

Tax reform, assuming Congress passes a measure similar to the proposals being bandied about, also is expected to boost the sector. Bernstein analyst Kevin St. Pierre said a reduction in the corporate income tax rate from the current 35 percent to the 20 percent outlined in the Republican-sponsored plan would boost bank earnings by about 15 percent in 2019 — 21 percent for consumer finance.

Bernstein has eight specific stocks set to outperform: Capital One Financial, Synchrony Financial, Ally, Citizens Financial, Huntington Bancshares, Key, Bank of America and Citigroup.

A friendly Fed

CFRA based its upgrade to overweight on "expectations that loan growth will slowly improve in 2018, the Federal Reserve will maintain a steady pace of interest rate increases as Jerome Powell takes the helm, and deregulation benefits will become more substantially realized. Consumer and corporate balance sheets are in solid shape, and even as rates rise, they will remain below historic levels," investment strategist Lindsey Bell said in a note.

Both Powell and outgoing Fed Chair Janet Yellen have indicated the central bank is likely to remain on a pace of gradual increases, with the Fed pointing to three hikes in 2018 on top of one widely expected for December.

While Bell notes that a flattening yield curve — the difference in rates between bonds of various maturities — is a trouble spot, Bell thinks that will ease ahead. Other analysts also contend that a flattening is more of a danger when rates are going lower, which they are not expected to do as the Fed hikes its benchmark.

Improving earnings and momentum also are considered key drivers for the sector.

"The sector's domestic dominance positions it well for any acceleration in economic activity," Bell wrote. "As 2017 comes to a close, unemployment remains at a very low rate, the consumer is confident and the housing market is showing some signs of strength following hurricane induced weakness."

CFRA's top-rated financials are Bank of America, Barclays, MetLife, Charles Schwab and XL Group.

WATCH: The case for valuation as an additional driver for banks.