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Buy Big Bank Stocks and Give Regionals a 'Breather': Merrill Lynch (Update 2)

Updated with comments on JPMorgan Chase from KBW analyst Frederick Cannon and Stifel Nicolaus analyst Christopher Mutascio, and also to correct the date of Citigroup's earnings announcement. Citi will report its third-quarter results next Monday, Oct. 15.

NEW YORK ( TheStreet) -- The apparent housing recovery may finally turn investor sentiment to undervalued money center banks and away from a couple of high-flying regional names.

While portfolio managers are "gravitating towards 'housing sensitive' stocks - benefitting regional banks," Bank of America Merrill Lynch analyst Erika Penala said on Tuesday that "money center bank stocks... will be bigger incremental beneficiaries to this theme."

Penala reinstated her firm's coverage of Citigroup (C - Get Report) and JPMorgan Chase (JPM - Get Report) with "Buy" ratings, while downgrading U.S. Bancorp (USB - Get Report) and Fifth Third Bancorp (USB - Get Report), which have both had much stronger recent earnings performance than Citi or JPM.

Among the 24 components of the KBW Bank Index (I:BKX), Citigroup and JPMorgan have the cheapest valuations to consensus 2013 earnings estimates, among analysts polled by Thomson Reuters, while some of the regional names are no longer bargains, but are trading "close to fair values," according to Penala.

The analyst said that "investors are incorrectly overlooking C and JPM on the housing theme, as both EPS power and market multiples are highly levered to a recovery. With consolidated loan loss reserves at 4.4% of loans for C and 3.3% for JPM versus 2% median of the large cap regional banks, the money centers have significantly more room to release reserves," which directly pads earnings results.

Penela also said that the Federal Reserve's next round of annual stress tests "should re-establish money centers as return of capital stories, and give investors confidence that these banks are on a smooth glidepath to Basel 3 compliance." According to BAC Merrill Lynch's analysis, Citigroup could increase its dividend payout from a penny a quarter, to a total annual payout of 60 cents during 2013, while JPMorgan Chase, whose "well-publicized synthetic credit loss had essentially invalidated its 2012 Federal Reserve capital return approval," could see its common share buybacks resume during the first quarter of next year.

Finally, the analyst expects capital markets revenue for both firms "could bottom in 2012," setting them up for a major earnings advantage over the regional banks beginning in 2013.

Here's a quick look at all four banks, with their stock and earnings performance, along with additional comment from Penala:

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