One of the stock market's biggest opportunities is being ignored

Reuters

• Bank stocks are underperforming the broader market this year, and Goldman Sachs sees an intriguing opportunity for investment
• Much of the bullishness stems from the big increase in capital available to be returned to shareholders following a series of successful bank stress tests

Banks are having a rough go of it this year, at least compared with expectations.

Once viewed as an area poised to benefit greatly from deregulation and higher lending rates, Wall Street firms have seen excitement wane as President Donald Trump's economic agenda has stalled and the Federal Reserve has been more dovish than expected.

This lack of enthusiasm has been reflected in share prices, with an index of the biggest banks returning 5.9% this year, roughly half of the benchmark S&P 500.

Amid all that's going on, investors simply aren't confident enough about the pace of inflation to bet on the higher interest rates that are supposed to boost banks.

Goldman Sachs disagrees on a couple of fronts.

For one, the firm's house forecast is for faster inflation than the market is anticipating. And as an extension of that, Goldman foresees Fed tightening coming more quickly than expected. As of Monday, economists surveyed by Bloomberg were predicting a 42% chance that the central bank would hike rates again this year.

"While portfolio managers are focused on the macro story, we believe micro tailwinds present an underappreciated opportunity for investors," a group of Goldman analysts led chief US equity strategist David Kostin wrote in a client note. "We recommend an overweight despite recent underperformance."

So what kind of "micro tailwinds" does Kostin have in mind? Here's a breakdown of the big three:

Increased capital return, particularly in the form of dividends

After banks across Wall Street passed the Fed's stress tests that took place in late June, they were allowed the capacity to increase capital returned to shareholders by $40 billion — roughly 43% more than in the previous year.

Considering that increased potential for cash distribution, Goldman banks analyst Richard Ramsden estimates that total capital payouts could grow at an average annual pace of 19% through 2020.

The possibility of increased dividends should attract equity income investors who are shunning the sector. These traders, who prefer stocks that serve as bond proxies and provide a periodic cash reward, are underweight the financials industry and represent a big opportunity for growth, according to Goldman.

Stock-price-boosting share repurchases

Ramsden also forecasts that buybacks for the largest banks will surge by 45% this year, which he thinks will lift reported earnings, return on equity, and share prices.

Throughout the eight-year bull market, repurchases have been an invaluable source of share appreciation. They're a win-win for corporations that want to push their stock higher by reducing shares outstanding while also signaling to the market that they see shares as undervalued. And, perhaps most important, it's a tactic that can generate returns during lean times, as it did during the S&P 500's five-quarter earnings slump, a period that saw the index still grind out a 1.5% gain.

Now that a great deal of money has been freed up for the purpose of capital return, Goldman says to expect buybacks to wield even more influence than usual. And the buybacks have been announced in force. Firms including Bank of America as well as JPMorgan and Citigroup raised their announced repurchases after passing their respective stress tests.

Appealing valuations

Amid the underperformance of bank stocks has come a compelling valuation situation. Goldman calculates that financial firms trade 0.5 standard deviations below its 10-year average relative valuation and says it ranks "among the most attractively-valued S&P 500 sectors."

Further, financials are the largest underweight position among hedge funds at the moment, according to Goldman data. In the end, this serves as the final piece to the investment puzzle for banks — if you believe in the first two points laid out above, this relative cheapness should make buying financials a no-brainer.

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