The investment of choice for bulls seeking risk, value and domestic growth? European banks.

The shares have jumped 28 per cent since a January low, but they're still trading at a discount to their two-year average, making the industry among the cheapest in the region. The cost of options protecting against bank stock swings this month reached the lowest level in more than five years versus those on the Euro Stoxx 50 Index. The lenders' rally will trump even exporters, which have climbed with the weak euro, says Alex Altmann at Citigroup, who recommends buying banks while shorting the broader index.

As the economy recovers, investors are honing in on companies that most benefit from growth at home. And European Central Bank asset buying is also helping earnings, with firms such as Intesa Sanpaolo SpA saying profit doubled in the first quarter as it sold government bonds. "We're seeing a substantial rotation into value sectors," said Altmann, Citigroup's head of equity-trading strategy in London. "Comments from the ECB lately really highlight credit growth as the key driver for any broad-based recovery. Lending is somewhat improving, and that's what got us more bullish."

Improving economy

Forecasts for the region’s growth have increased. Lending to companies and households is improving too, expanding in March for the first time in three years, according to the ECB. Annual bank earnings are poised to reach a five-year high, according to analyst estimates. At 13.3 times estimated earnings, the valuation of the Euro Stoxx Banks Index is about 16 per cent lower than the rest of the market. The lender’s gauge fell 1.2 per cent at 8:52 a.m. in London, while the Euro Stoxx 50 lost 0.6 per cent. Investors see lenders as the most undervalued industry group in Europe after energy, according to a Bank of America Corp. survey in May. Even so, they cut their allocations to the sector for a second month, the data showed. Banks and insurance stocks were the most-favored sectors as recently as March. For Ralf Zimmermann at Bankhaus Lampe KG, the risks now outweigh the rewards. Investors should trim their exposure because growth in Europe is still fragile and any shock from Greece’s debt negotiations could trigger a selloff, he said. “I would close this trade now,” Zimmermann, an equity strategist at Bankhaus Lampe, said from Dusseldorf. “We’re in a different environment than we were six months ago, where growth is likely to be slower. If the market suffers even just a temporary risk-off moment, then banks will underperform.”

More bullish

Yet traders are getting more bullish. Implied volatility, the key gauge of options prices, for three-month contracts on the Euro Stoxx Banks Index fell 32 per cent since a high in January, more than the 22 per cent drop for the broader measure. The most-owned contract is a call that will profit with a 0.9 per cent increase in the lenders' gauge by next month. "Financials have been a clear underperformer during the global financial crisis and the euro-zone sovereign crisis, and have hardly recovered any ground versus the index," Andrew Sheets, chief cross-asset strategist at Morgan Stanley in London, wrote in a May 17 note. "The sector is one of our most preferred globally."

Bloomberg