In the strong rally in the stock market since the beginning of the year, financials and transports have provided exactly the kind of leadership that many equity strategists look for and that can be the basis for a true bull market rally. Given the good price appreciation in many stocks, it may be smart to stay in the financial sector but switch to stocks with profitability that is the best in industry.

The banking analysts at Stifel Financial Corp. (NYSE: SF) made just that call today. Their research noted that the recent rally in bank stocks may have been spurred on in part by what they consider an erroneous view that an increase in the 10-year U.S. Treasury bond yield is a significant driver of improved earnings. They also pointed out that the false notion that the Federal Reserve will raise short-term interest rates in the near-term has resulted in very little differentiation in the valuations between highly profitable banks and those that are not as profitable. Stifel Nicolaus views this lack of differentiation as a relative gift to investors who are looking to upgrade the quality of the banks within their portfolios.

If the market is indeed allowing investors to purchase low-risk franchises with strong management teams that are generating profitability ratios well in excess of the industry’s average at “no extra charge,” then it may make sense to switch to those names. In their call today, Stifel Nicolaus analysts upgraded U.S. Bancorp (NYSE: USB) and mortgage giant Wells Fargo & Co. (NYSE: WFC) from Hold to Buy. The main reason for the upgrade is that both banks generate among the highest returns on assets (ROA) in the large cap bank universe.

Stifel Nicolaus downgraded Cincinnati-based Fifth Third Bancorp (NASDAQ: FITB) from Buy to Hold strictly on valuation. Both KeyCorp (NYSE: KEY), which they feel has no earnings upside at all, and Comerica Inc. (NYSE: CMA), which is viewed as way ahead of its fundamentals, were cut to Sell.

Basically what investors can take away from this call is that selling stocks that have a regional footprint and moving to large cap banks with national exposure and greater profitability makes good sense after the strong rally. If the bull market rally continues in 2013, investors will definitely want to keep financial stocks as part of a diversified portfolio.

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