Financial stocks have rallied hard, but there is plenty of potential for them to provide more returns.
The Financial Select Sector SPDR exchange-traded fund, home to the large investment banks, pure lenders such as KeyCorp, asset managers such as State Street, and other financial services companies -- has gained 26% this year, outpacing the S&P 500 by 3 percentage points. The rally, which briefly took the index to a record high, included a surge the week before the Federal Reserve cut interest rates in mid September.
Lower rates are key for banks right now, so it was positive news that the Fed indicated more cuts could follow as long as inflation continues to moderate. Lower rates are meant to keep the economy, recently growing at annual rates in the low single digits, expanding.
That would enable lenders to continue to increase their loan volumes. It also means banks' funding costs would drop, while the long-term interest rates that lenders make their money on remain elevated because of the bond market's optimism about the economy's long-term health.
Meanwhile, if the stock market can continue to gain, a variety of financial firms will benefit. Investment banks will see higher trading and capital markets revenue, while asset managers' fee revenue will rise because their assets under management will grow.
The best news of all is that more gains seem plausible for financial stocks.
Financials may still have some catching up to do versus the S&P 500. They have underperformed the index by almost 30 percentage points over the past five years, so if the index continues to rally because economic data is showing growth, then investors could easily continue to favor financials. Those companies tend to see larger increases to earnings when the economy expands.
Consistent with that, there seems to be more money that could pour into the sector. A Morgan Stanley survey of portfolios excluding exchange-traded funds shows that investors' allocation to the sector is in its fourteenth percentile since 2010. That is the lowest among the 11 sectors that comprise the S&P 500.
"This creates opportunity in a sector that we upgraded to overweight last week given rebounding capital markets activity, a better loan growth environment in 2025... and attractive relative valuation," writes Mike Wilson, Morgan Stanley's chief U.S. equity strategist.
Relative valuation is telling. The financials fund trades at just over 16 times the aggregate earnings that analysts for companies in the fund expect for the coming twelve months. That's a near 25% discount to the S&P 500's just under 22 times, which is about in line with the average discount seen over the past decades, according to Barron's calculations using FactSet data. This means as long as the market's thesis about the economy holds true, financials are still cheap enough to participate in an ongoing bull market.
Zions Bancorp, for example, is up just 16% this year, while the S&P 500 has gained . It trades at 11 times earnings, about half the S&P 500's multiple. That's especially cheap; it averages a multiple that is about two thirds of the market's valuation over the past ten years. That means higher earnings can boost the stock.
Analysts expect almost 4% annual revenue growth from this year through 2026, bringing the total to about $3.3 billion. The traditional banking and lending business is expected to see slow growth, while the still small asset-management business is projected to grow 7% annually to $70 million.
What's more, net interest margins, the percent of interest revenue that the bank keeps as profit, is expected to climb . Expenses such as salaries will rise a bit, but not enough to pressure margins. That can bring earnings per share up almost 6% annually to $5.10 in 2026, according to consensus forecasts among analysts tracked by FactSet. As earnings grow, the company can continue to pay higher dividends.
All in, if the stock maintains its current multiple by the end of 2025, it would trade into the mid-50's. Adding next year's expected dividend, the stock's total return would be about 12%.
Zions reports third-quarter earnings on Monday. If management confirms a strong outlook, the stock could rise.
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