Heard from traders: Europe's bank rally is just beginning. Buy financials

Shares of European banks have risen 28 percent since a January trough, but they’re still trading at a discount to their two-year average, making the industry among the cheapest and the most attractive in the region, says Bloomberg.

This month, the cost of options protecting against bank stock fluctuations touched the lowest level in more than five years versus those on the Euro Stoxx 50 Index.

Alex Altmann, Citigroup’s head of equity-trading strategy in London, recommends to buy banks while shorting the broader index, noting that the lenders' rally will trump even exporters.

As the economy regains ground, investors are turning their heads towards firms that most benefit from growth at home. And European Central Bank asset buying is also helping earnings, with companies such as Intesa Sanpaolo SpA saying profit doubled in the first quarter as it sold government bonds.

“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,” said Altmann.

According to the ECB, lending to firms and households is also improving, expanding in March for the first time in three years. Yearly bank earnings are poised to reach a five-year high, according to analyst forecasts. The valuation of the Euro Stoxx Banks Index is about 16 percent lower than the rest of the market, at 13.3 times estimated earnings.

As showed a Bank of America Corp. survey conducted in May, investors see banks as the most undervalued industry group in Europe after energy. Even so, they cut their allocations to the sector for a second month, according to the data. As recently as March, banks and insurance stocks were the most-favored sectors.

Implied volatility, the key indicator of options prices, for three-month contracts on the Euro Stoxx Banks Index dropped 32 percent since a high in January, more than the 22 percent drop for the broader measure. The most-owned contract is a call that will profit with a 0.9 percent increase in the lenders’ gauge by next month.

Andrew Sheets, chief cross-asset strategist at Morgan Stanley wrote in a note a week ago that financials have been clearly underperforming during the global financial crisis and the euro-zone sovereign crisis. Now they have barely regained any ground versus the index. “The sector is one of our most preferred globally.”

Ralf Zimmermann from Bankhaus Lampe KG, however, warns that the risks now outweigh the rewards. Because growth in Europe is still vulnerable and any shock from Greece’s debt negotiations could trigger a selloff, investors better cut their exposure.

“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.”