My favorite 2014 trade breaks out... with more gains ahead

My favorite trade for 2014 is breaking out.

Big banks like JPMorgan, Citigroup, and Bank of America are up an average of 13% in four months. Meanwhile, the S&P 500 is up just around 4%.

If you took my advice to buy big banks in December, you're sitting on solid profits.

But the big gains in these stocks are just getting started.

Let me explain...

In December, I told you several catalysts would push the banking sector higher this year. Now, these trends are taking form...

For example, one of the catalysts I mentioned was rising interest rates.

Rising interest rates are widely viewed as a negative for stocks. Borrowing costs for consumers and businesses move higher. Plus, interest rates could persuade investors to move their money out of stocks and into interest-paying alternatives.

But higher interest rates are great for banking stocks. That's because the spread between the cost to borrow money and the actual rates banks can charge their customers widens – creating bigger profits.

Banks have plenty of cheap money at their disposal. (The average interest rate on a savings account, for example, is about 0.4% right now.) But if interest rates on long-term debt rise, banks can lend that money back out at much higher rates – say, in a 30-year mortgage at 4.1%. So the more interest rates increase, the more money banks make.

Since my December essay, interest rates have gone virtually nowhere. But it looks like the Federal Reserve is finally getting ready to raise rates.

The Fed has announced several reductions in its bond-buying program (a form of quantitative easing meant to keep interest rates low) this year. And Federal Reserve members have recently stated that the Fed could raise rates (tighten) sooner rather than later.

ust the talk of tightening has been enough to push interest rates higher over the past few weeks. The 10-year Treasury bond jumped from 2.35% to 2.6% in the past 30 days. That's a huge move in a short period. And it's likely rates will continue to rise this year.

Banks are also being forced to sell – or spin off – non-core assets.

Large-cap banks have huge trading divisions, credit-card portfolios, and asset-management businesses worth billions of dollars.

But since the 2008-2009 credit crisis, the government has been putting new rules and regulations in place to reduce risks for banks. And with new government regulations coming, banks are looking to sell off these non-core assets.

These assets are in high demand. There are plenty of hedge funds, private-equity shops, and regional banks that would line up to buy these cash-cow businesses. So large banks can sell these assets for a great price, increase their cash flow, and avoid dealing with the new government regulations. Any news of a sale will push big-bank shares higher.

But the most important trend that will push the sector higher is banks returning capital back to investors in the form of dividends.

After the credit crisis, the government placed restrictions on banks paying dividends to investors. But with bank balance sheets stronger than ever, the Federal Reserve is finally giving big banks permission to raise their dividends.

Wells Fargo has raised its dividend by 52% since January. Bank of America just raised its dividend last month for the first time since the credit crisis. And JPMorgan got the thumbs-up in March to raise its dividend and buy back $6.5 billion of its stock. (When a company buys back its shares, fewer shares are available in the open market. So existing shareholders get a slightly bigger portion of earnings.)

This is a big deal.

Banks are one of the most-hated sectors in the market.

Since the credit crisis, the government has continued to bring lawsuits against the industry. Bank of America, JPMorgan, and Citigroup recently paid more than $36 billion in fines to settle mortgage-related activities during the crisis. (Most of these legal woes are now largely behind these companies.)

And the fact most of these names had to be bailed out for taking on excess risk during the credit crisis left a bad taste in the mouths of investors.

But now that large banks are being allowed to increase their dividends and buy back stock, sentiment is shifting. And big-bank stocks are breaking out.

Bank of America is up around 15% in four months. Citigroup and JPMorgan are up around 10% and 11%, respectively, in the same time frame. Meanwhile, as I told you earlier, the S&P 500 is up just around 4%.

As interest rates rise and banks continue to perform well and reward shareholders, shares will head higher. Bank stocks should easily outperform the market over the next six to 12 months.

And importantly, these stocks are still cheap today. The big banking fund, the Financial Select Sector SPDR Fund (NYSE: XLF, Stock Forum), trades at just 15 times earnings. XLF's holdings include Bank of America, Citigroup, JPMorgan, and Wells Fargo. For comparison, the S&P 500 trades at 18 times earnings.