Bank stocks have underperformed the S&P 500 index this year and have struggled to stage any kind of a rebound after falling from their previous highs. Bullish investors say that disappointing performance will end soon. The KBW Nasdaq Bank Index is down 0.1% since the beginning of the year, while the S&P 500 is up 4.0%.

Many banks plan to boost dividends after passing the Federal Reserve’s latest stringent round of stress tests, and that could fuel a nice boost to share prices of a select number of U.S. financial firms. The Fed now is allowing many banks to return a greater portion of their earnings to shareholders, which is exactly what they are doing. Banks plan to increase dividends by 25% on average, says JPMorgan Chase & Co. analyst Vivek Juneja. This could push dividend yields to levels that greatly exceed the rest of the financial sector and the broader market, according to MarketWatch.

Nine banks whose planned dividend increases will bring their dividend yields to around 3.00% or higher include Huntington Bancshares Inc. (HBAN), KeyCorp (KEY), Wells Fargo & Co. (WFC), BB&T Corp. (BBT), Regions Financial Corp. (RF), Fifth Third Bancorp (FITB), JPMorgan Chase & Co. (JPM), SunTrust Banks Inc. (STI), and US Bancorp (USB).

 Stock/Index  Implied Dividend Yield
 Huntington Bancshares  3.76%
 KeyCorp  3.47%
 Wells Fargo  3.21%
 BB&T  3.20%
 Regions Financial  3.11%
 Fifth Third  3.06%
 JPMorgan  3.05%
 SunTrust  3.04%
 US Bancorp  2.98%
 SPDR Financial Select Sector ETF  1.69%
 S&P 500  1.94%

Source: MarketWatch; Data as of July 2

Dividend Boost

Although banks have received a stamp of approval following the Fed's stress tests, the increasing dividends, coming from both big and small banks alike, are a reflection of tax reform benefits and stronger capital ratios due to tepid loan growth, according to Juneja. With greater capital ratios, banks have more room to boost shareholder returns without hitting regulatory lending constraints.

As equity returns depend on both capital gains from stock price returns and on dividend income, a higher dividend yield increases the amount of return that doesn’t depend on stock price performance. Stocks with higher dividend yields represent a relatively cheap way to invest in a stable source of income.

With worries of being in the later stages of the economic cycle, not to mention the threat of trade wars, weighing on the overall market, dividends represent a more stable source of return as most companies try to maintain their payouts even in a recession. As investors turn to more defensive, dividend-paying stocks, this could also help to give these shares an added boost even in the case of a downturn. (To read more, see: US Stocks Face Grim Decade of Low Returns: Morningstar.)

Good Value

The bank stocks underperformance might suggest they are relatively undervalued compared to the rest of the market.

According to a mathematical model built by Bespoke Investment Group macro strategist George Pearkes, which predicts bank stock prices by utilizing two-year Treasury yields and investment-grade bond spreads as model inputs, bank stocks are currently priced 9% below their fair values.

The earnings picture is also looking positive for the financial sector. Next to the energy sector, financials have the best near-term earnings outlook with 21% earnings per share (EPS) growth expected in the second quarter, 40% growth expected for the third quarter, and 28% growth expected for all of 2018, according to a report from Goldman Sachs. 

On a more bearish note, Piper Jaffray chief market technician Craig Johnson says the technical outlook for the financial sector is “cloudy,” with the number of financial stocks advancing being outpaced by the number of those declining. As most financials are trading below their 200-day moving averages, it will take a really sustained boost to fuel more positive momentum. (To read more, see: Why Bank Stocks May Fall 8% Further.)