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The Deal: Sentiment Turns Sour on Bank Stocks

NEW YORK ( The Deal) -- Strategists are turning bearish on bank stocks as JPMorgan Chase (JPM - Get Report) negotiates a potential $11 billion legal settlement while investors digest the Fed's somber assessment of economic growth.

The S&P 500 banks stocks index hit a five-year high of 203.36 last month but has shed around 3% since last Wednesday when the Federal Reserve decided to continue its stimulus program, citing an uncertain outlook.

JPMorgan has been the worst performer among listed American investment banks for the year to date, though it has still gained around 15%. The bank has been laboring with legal woes stemming from the so-called London Whale trading debacle and its sale of mortgage-backed securities.

Leading the pack is Morgan Stanley (MS) with a gain of around 40% as it overhauls its business to emphasize wealth management while cutting riskier trading and commodities operations.

Several strategists believe banks stocks have seen their best run for now. Barclays' head of U.S. equity portfolio strategy, Barry Knapp, said he was underweight banks, citing limited room for margin growth, while new loan growth remains sluggish. He said the outlook for investment banks appeared more fraught than that for regionals.

"Regional banks and Wells Fargo could benefit from a loosening of credit but for the big money center banks, why would you buy an entity leveraged 20 times with a return on equity of 8? You need to believe ROE will get to double digits," he said at the bank's Global Outlook conference on Thursday. Knapp said the final form of capital requirements would be critical to banks' returns, noting their performance was "terrible" during the 1950s when the sector was heavily regulated.

His views have been echoed by Lazard's managing director of financial institutions group, Jim Spencer, who has noted that new regulatory and capital requirements may jeopardize banks' appeal to investors if their returns fall much further.

Even the bulls have moderated their commentary on banks since earlier this year. Bank of America Merrill Lynch's (BAC) chief investment strategist, Michael Hartnett, said that while regulatory headwinds were strengthening, the positive macro story of a recovering housing market offset these negatives.

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