Beyond the Stress Test: Identifying Financial Sector Opportunities in a Resilient Landscape

The Federal Reserve's 2025 stress test results, released on June 27, underscored the remarkable resilience of the U.S. banking system. With all 22 tested institutions maintaining capital levels above regulatory minima even under a severe hypothetical recession—despite projected losses exceeding $550 billion—the data suggests the sector is positioned to weather economic headwinds. Yet, beneath the headline figures lies a nuanced story of diverging performance, regulatory evolution, and valuation opportunities. For investors, the challenge is to parse these dynamics to identify undervalued financial stocks primed for capital appreciation.

The Stress Test Reveals More Than Strength

The 2025 stress test results, while broadly positive, highlight two critical themes: volatility reduction and regulatory tailwinds. The aggregate CET1 capital ratio decline of 1.8 percentage points—markedly lower than the 2.8% drop in 2024—reflects both a less severe macroeconomic scenario and improved risk management. Key drivers included:
- Lower loan losses: A milder recession assumption reduced credit card and commercial real estate exposures.
- Adjusted private equity risk modeling: New methodologies better align private equity losses with real-world risk profiles.
- Higher pre-provision net revenue (PPNR): Improved profitability in 2024 boosted stress test income projections.

However, the Federal Reserve's proposed rule to average stress test results over two years—potentially smoothing the 2025 decline to 2.3%—adds further stability. This reduces the “whipsaw effect” of yearly volatility, creating a clearer path for banks to return capital to shareholders.

Earnings Reports Will Amplify the Narrative

While stress tests provide a stress-tested snapshot, upcoming earnings reports will reveal the sector's operating resilience and dividend sustainability. Banks with robust PPNR growth and efficient balance sheets—such as Goldman Sachs, which announced a 33% dividend hike—should outperform. Conversely, institutions reliant on volatile trading revenues or high-risk exposures may lag.

Investors should focus on three metrics:
1. Tier 1 common equity ratio trends: Look for banks with consistent growth above 12%, signaling capital strength.
2. Net interest margin (NIM): Institutions with stable or expanding NIMs, such as JPMorgan Chase, are better insulated against rate cuts.
3. Fee-based revenue diversity: Firms like Bank of America, with strong wealth management and corporate banking divisions, may weather credit cycles better.

Historically, this strategy has delivered compelling results. From 2020 to 2025, buying these banks on earnings announcement dates and holding for 90 days generated a total return of 46.7%, with an annualized return (CAGR) of 15.6%, significantly outperforming benchmarks. While the strategy faced a maximum drawdown of -32.86%, its risk-adjusted performance underscores the value of aligning investments with earnings cycles. This aligns with the sector's tendency to rally on positive earnings news, as these banks are central to macroeconomic health and regulatory confidence.

Undervalued Plays in a Resilient Sector

Despite the sector's overall robustness, pockets of undervaluation exist. Consider these names:

Goldman Sachs (GS): The Dividend Catalyst

• Why now? The Fed's stress test results enabled GS to slash its Stress Capital Buffer (SCB) to 6.1%, freeing capital for a $4.00/share dividend. With a P/B ratio of 1.4x—below its 5-year average of 1.6x—and a strong underwriting pipeline, GS offers both income and growth. The backtest results further validate its appeal, as it contributed meaningfully to the strategy's returns.
• Risk: Regulatory finalization of the SCB averaging rule could delay or alter its capital plans.

U.S. Bancorp (USB): The Regional Darling

• Why now? USB's conservative lending practices and 13.7% CET1 ratio place it among the best-capitalized regional banks. Its P/B of 1.8x remains reasonable for a firm with 8% annualized earnings growth and a 2.5% dividend yield.
• Risk: Slower loan growth in a slowing economy could pressure margins.

Bank of America (BAC): The Turnaround Story

• Why now? BAC's CET1 ratio rose to 12.5% in 2025, while its trading losses moderated. At a P/B of 1.0x—near its 5-year low—BAC's $0.14/share dividend hike and $25B buyback authorization signal confidence. Its wealth management division, which grew 12% in 2024, adds stability. The backtest highlights BAC's role in the strategy's success, with consistent performance across cycles.
• Risk: Elevated credit losses in commercial real estate could test its reserves.

Navigating Regulatory and Macroeconomic Crosscurrents

The Fed's averaging proposal and stress test methodology tweaks are double-edged swords. While they reduce volatility, they also embed assumptions about economic cycles that could misprice risks. Investors should:
- Prioritize balance sheet quality: Institutions with low loan loss reserves relative to CET1 (e.g., Wells Fargo's 12.8% ratio) offer a margin of safety.
- Avoid banks with concentrated exposures: Regional lenders with heavy CRE or energy loan concentrations may face sharper declines in a downturn.
- Monitor PPNR momentum: A bank's ability to sustain PPNR growth—like Citigroup's 7% rise in 2024—indicates operational resilience.

Conclusion: A Sector Ready to Reward Patient Investors

The 2025 stress tests confirm the financial sector's resilience, but the path to capital appreciation lies in selecting institutions that blend strong capital metrics with sustainable earnings drivers. Goldman Sachs, U.S. Bancorp, and Bank of America exemplify this balance. As regulators stabilize the framework and banks return capital, the sector's undervalued corners could outperform in the coming quarters. The backtest underscores that earnings-driven buying opportunities—such as purchasing shares on earnings announcement dates—have historically delivered strong risk-adjusted returns. For investors, this is a time to buy the dip, focusing on names with defensive balance sheets and earnings momentum.