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5. Large Cap U.S. Banks

After a mixed set of earnings results, with some like Wells Fargo ( WFC) reporting blowout earnings and others like Citigroup ( C) and Goldman Sachs ( GS) still struggling to grow sales and profit, the large-cap bank sector is filled with both landmines and undervalued stocks.

"We believe the Large Cap Banks can sustain their current price rebound due to their earnings recovery power going forward. We also estimate that our Large Cap Bank dividend yield should exceed the S&P 500 yield for the first time since the beginning of this recession and financial crisis," writes Marty Mosby of Guggenheim Securities in a February note that details an 18% price target increase for the sector. It's a signal that January stock gains aside, expectations are still high for 2012 investment gains.

As of Feb 6., the Russell 1000 Financial Services sector is up nearly 12% after posting a near 13% drop in 2011. Within the investment banking and brokerages subgroup, those gains are nearly 18% after an even sharper 8% 2011 slide.

Mosby highlights U.S. Bank ( USB), Bank of New York Mellon ( BK) and Wells Fargo ( WFC) as the banks with the largest upside to Guggenheim's price estimates, each with a potential 20%-plus gain. The banks also may be best equipped to handle twists and turns in the European debt crisis and the still fragile U.S. recovery. "We believe that even if the operating environment turns unfavorable again and investors' aversion to risk regains strength these stocks have enough momentum to still sustain a positive return to risk outlook," writes Mosby.

If macroeconomic risks to the banking sector were to stabilize, Mosby targets Bank of America ( BAC), Regions Financial ( RF), SunTrust Bank ( STI) and Zions Bancorporation ( ZION) as stocks that could double in price.

Even with a slow 2012 deals and trading start, investment banks may also be primed for a continued share price recovery after some shares were nearly halved. Prior to Tuesday's mega commodities merger with Glencore buying Xstrata for $41 billion in a deal that may net investment banks roughly $150 million in fees, advisory fees and trading volumes off by nearly 50%. But a current lull may be outdone by recovering asset prices.

"The most positive sign in the early stages of 2012, however, is improvement in asset prices," writes Goldman Sachs analyst Daniel Harris in a February note. Tighter credit spreads, investment banking backlogs and a European credit recovery may all be tailwinds. Harris favors fee earning investment banks like Morgan Stanley ( MS) over trading revenue based firms like Charles Schwab ( SCHW) and Stifel Financial ( SF).

"We note that the second half of 2011 was abysmal, so the first quarter year-over-year comparison does not need to be favorable in order for 2012 to end up materially better than 2011," writes JMP Securities analyst David Trone of investment banks in a February note.

Rising markets may not lift all banks stocks, however. Community banks may suffer from a low interest rate environment that will cut at the net interest margin they earn on deposits. In February, the Federal Reserve indicated that it will continue to keep short term interest rates through 2014, keeping the yield curve flat and cutting at a key profit center for smaller lenders.

"With a high probability of a sustained low-rate environment, which will lead to profitability erosion, upside from current valuations is limited while downside is meaningful should the economic recovery falter," writes R.W. Baird analyst Bryce Rowe in a February note. Rowe recommends a short of Bank of Hawaii ( BOH) and a long position in First PacTrust ( BANC) and The Bank of Kentucky ( BKYF).

For bank investors, Deutsche Bank analyst Matt O'Conner highlights the Federal Reserve stress test results due in mid-March, the implementation of the Volcker Rule and credit card interchange fee litigation due to go to court in September as industry catalysts.

Bank of America investors should watch for a settlement of private label mortgage securities and a resolution of similar suits with MBIA and the New York State Attorney General, while Citigroup investors should watch for an upcoming option to sell a piece of its Morgan Stanley Smith Barney stake in May, according to O'Connor. Finally, PNC Bank ( PNC) investors should watch its closing of a bank branch purchase from RBS ( RBS) and the Fed stress tests will reveal whether Regions Financial has made progress in repaying TARP funds received during the crisis.

For more on bank stocks, see 5 overbought bank stocks and why Bank of America may hit $30 .

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