Big US investors bet heavily on financial stocks in the recently completed quarter and hope to ride the sector, which has been a market basket case for several years.
No other sector has been as besieged by bad news as the banks, where a scandal seems to erupt monthly, be it J. P Morgan Chase's "London Whale" trading loss or accusations that Barclays Plc rigged the short-term LIBOR rate.
At the same time, banks have been among the strongest performers in the S&P 500 this year, attracting prominent hedge fund managers and big investment firms betting their shares are still undervalued due to the risk of bad headlines and the uncertain US economy.
"Earnings production is moving toward a normal condition and it's hard to point to a group that has been more out of favour than bank stocks," said Keith Wirtz, chief investment officer at Cincinnati-based Fifth Third Asset Management, which went bullish on banks this year after three years of being "underweight."
"As we look out to the next three to five years, it's inappropriate to have any kind of underweight bet on the group," said Wirtz, who helps oversee $14.7 billion in assets.
With year-to-date gains of about 15 percent, financials rank third among S&P sectors in 2012, behind technology and telecommunications. The sector bests the S&P 500's 11.7 percent rise, even though the rally in financials has stalled recently.
However, financials are still down more than 60 percent from a peak in 2007. The steady drum beat of scandal has depressed valuations even as earnings growth has been relatively steady.
Nonetheless, second-quarter earnings growth for financials was 63.6 percent, the highest of any S&P sector, according to Thomson Reuters data. It was more than four times the growth rate posted by industrials, in second place with 15.4 percent.
"Even though they're one of the more volatile sectors, they're less volatile than they were last year, when we were also concerned about Europe and growth," said Marty Mosby, large-cap bank analyst at Guggenheim Partners in Memphis, Tennessee. "That's because they continue to make progress in building their earnings."
Many of the biggest financials trade well below Thomson Reuters StarMine's measure of intrinsic value, or where StarMine estimates a stock should trade based on its likely growth path.
Based on Monday's closing price, J. P Morgan is trading at half its intrinsic value, making it more undervalued than 90 percent of all companies. Bank of America shares would also have to double to meet their intrinsic value, while Citigroup Inc would need to soar almost 190 percent. Based on this metric, only 2 percent of companies are more oversold than Citigroup, according to StarMine. According to Bespoke Investment Group, 88 percent of financial stocks are trading above their 50-day moving average. That is a sign investors have been rotating into the sector, "which tells us that investors are positioning themselves for another leg higher."
Eric Mindich, who runs Eton Park Capital Management, is among the hedge fund managers taking large stakes in the sector. He said in a quarterly regulatory filing that he owned 5.1 million shares in Morgan Stanley and had the right to acquire another 21.5 million shares at an undisclosed price.
Mindich also made changes to his holdings in Citigroup. He owned 5.5 million shares at the end of the first quarter and said he had the right to acquire 12.7 million shares at an undisclosed price at the end of second quarter.
BlueMountain Capital, another hedge fund, initiated a new position in Citi of about 623,000 shares, and increased its stake in J. P Morgan Chase as well.
On the flip side, Dinakar Singh's TPG-Axon Capital Management sold its exposure to J. P Morgan Chase, which reported an unexpected and enormous trading loss this year, stemming from the infamous "London Whale" trade. Singh no longer lists J. P Morgan as a holding after owning 3.1 million shares during the first quarter.
Even with the trading loss, J. P Morgan should be one of the top S&P companies this year in terms of net income, says Dick Bove, banking analyst with Rochdale Securities LLC in Lutz, Florida. The stock was pressured following the news of the loss, but remains up more than 11 percent in 2012. "There's a huge disconnect between what is going on in the business and the perception of what's going on," said Bove.