NEW YORK ( TheStreet) -- Goldman Sachs on Monday raised its target for the S&P 500 by 4% to 1,625, on expectations that economic growth will accelerate. The analysts expect financials to lead the markets higher in 2013, as investors begin to favor growth-sensitive sectors. Life insurers, consumer lenders, asset managers and banks are expected to outperform within the financials space. Financial stocks have rallied 27% in the last 12 months, according to Goldman, as the economy improved and housing turned the corner. The Federal Reserve's annual stress tests showed that banks have continued to make significant progress in building capital. Last week, the regulator approved the capital return requests of 16 out of the 18 largest banks, although JPMorgan Chase ( JPM) and Goldman Sachs ( GS) were given only "conditional" approvals. But with rock-bottom interest rates, banks continue to see margin pressure, while global macro-economic concerns continue to weigh on the market. On Monday, a decision to tax bank deposits as part of Cyprus' bailout package was roiling markets, with financials heading lower. Still, Goldman analysts in a report published Monday morning listed five reasons why they were bullish on financials. First, improving GDP growth will benefit bank stocks in the long run, as loan growth accelerates. Goldman's economists forecast the economy will expand by 2% in 2013 and 2.9% in 2014. Next to materials, financials are the most sensitive to economic growth, the analysts wrote. Second, Goldman expect the yield on 10-Year U.S. Treasury bonds to rise to 2.5% in 2013 and 3% in 2014, which will help banks by steepening the yield curve. "Although we still expect
the federal funds target rate to remain near zero until early 2016, higher intermediate yields and better growth are incrementally positive and should make investors more comfortable with the timing of eventual net interest margin improvement." KBW analysts in a report on Monday also noted the strong correlation between bank stocks and bond yields, but they are more bearish on where yields are headed. "For the bond yield to move higher from its current trading range around 2.0%, we would likely need to experience a more robust job market in the U.S., with employment stats encouraging the Federal Reserve to begin reversing its very accommodative position," the analysts wrote. "Therefore, unless a more robust job market develops in the near term, Fed action is likely to keep the yield curve depressed and limit the further upside to many financial stocks."
KBW recommends conservative investors should consider a more defensive stock portfolio. Goldman's third reason for financial names to outperform the broad market is that higher returns on equity should lead to higher valuations. Financial stocks are still producing returns on equity below 10% with price-to-book ratios of 1.1, according to the firm. The returns may stay low for some time as banks meet higher capital requirements and increased regulatory costs, but the analysts see median ROE improving to 10% by 2014. Fourth, following the results of the Federal Reserve's Comprehensive Capital Analysis and Reviews (CCAR), banks are increasing dividends and share buybacks by 16% and 17%, respectively, versus last year. "Assuming payout ratios increase by a comparable amount in 2014, effective yields could reach 6.7% for the industry (2.5% dividend yield)," according to Goldman. Fifth, rising home prices should boost earnings. Goldman economists expect home prices to rise 3% through third quarter of 2013 and then 4% through the third quarter of 2014. Goldman Sachs financial analysts believe that a 5% rise in home prices would increase their earnings estimates by 13%. "While the recovery in housing is well understood, it continues to provide strong support for earnings and credit trends with risks skewed to the upside," the analysts wrote. -- Written by Shanthi Bharatwaj from New York