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Bank on Financial Stocks Surging Soon

The sector has lagged, but is about to break out


Financial stocks have been the sector group everyone loves to hate. No surprise, given that these were at the companies at the epicenter of the housing-related economic meltdown of 2007 through 2009.

So after an initial bounce in early 2009 as it because clear a full-scale nationalization of the financial system was off the table, and that the vast majority of banks would survive the recession, financial stocks have lagged the broad market. So while the S&P 500 has moved to fresh two-year highs, the Financial SPDR (NYSE: XLF) is still struggling to overcome its April high.

financials etf chart

That’s set to change, with the financial sector enjoying a burst of vitality and firms seen as some of the best stock picks. Over the past month, the sector has been demonstrating impressive relative strength against the broad market. Since December 1, the XLF is up more than 14% compared to an 8% gain in the S&P 500. You can see the change in trend in the chart above, which shows how the KBW Bank Index ETF (NYSE: KBE) broke out of its post-April funk back in December. And with the on-balance volume moving higher, it’s clear that investors are busily accumulating positions for further gains.

The question is: Can the performance continue? By all indications, the answer is yes.

The economy is improving. New jobs are being created. Regulatory reform is behind us and was less onerous than expected. The housing market is stabilizing, as I discussed in a recent MSN Money column. New loan origination is picking up again. And most importantly, with long-term interest rates moving higher and the Fed keeping short-term rates pegged near zero, banks are enjoying the widest net interest margins since the early 1990s. Since banks borrow based on short-term rates and earn long-term rates, this translates directly into earnings power.

Indeed, Jason Goldberg, who heads the bank equity research team at Barclays Capital, notes that favorable GDP growth, a rising stock market, and stable short-term interest rates in 2011 bode well for the performance of financial stocks in the New Year. Since 1949, there have only been eight years where these three factors were present; and in all eight years banks stocks finished higher. And they outperformed the broad market in six of those eight years.

If you’re looking for a leveraged way to express a positive opinion on the future of the economy — look no further than Zions Bancshares (NASDAQ: ZION). If I could buy just one stock and hold it all year, ZION is the best stock for 2011.

Zions sits at the very center of the real estate blast zone, with a majority of its operations concentrated in Nevada, Arizona, and California. It’s one of the larger regional banks in the United States with $50 billion in assets. The company was hit hard by the housing bubble and hasn’t been profitable since the second quarter of 2008. Carrying a total of $2.1 billion in non-performing loans (or 5.9% of total loans), the company posted a loss of $80 million dollars last quarter.

Yet things are improving — and as they do, the company’s exposures to some of the fasting growing regions of the economy will transition from a liability to an asset. Analysts expect Zions to return to profitability in the second quarter of 2011 and earn $88 million or 38 cents per share. This is up from a loss of $9.92 per share in 2009 and an anticipated loss of $2.16 per share for 2010.

In addition, Zions has been steadily stabilizing its capital base with its total capital ratio not at 16.5%, up from 11.7% in 2007 and above the peer average of 15.9%. Overall, the company has managed through the worst credit downturn in a generation and is now ready to benefit from the rebound.

Zion is my favorite, but other banks that look strong include Western Alliance Bancorp (NYSE: WAL), Wells Fargo (WFC), and JP Morgan (JPM).

Disclosure: Anthony has recommended ZION to his newsletter subscribers.

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