The S&P/TSX bank index has jumped 12.2 per cent since Nov. 4 – its most recent low – but, according to the most relevant valuation measures, the sector remains attractive to investors.
The price-to-book-value ratio is the most conventional valuation measure for bank stocks. The first chart below shows why: Price-to-book value has been an excellent predictor of future bank-stock performance.
The orange line on the chart represents the average price-to-book value for the S&P/TSX bank index. The figures are plotted inversely to better show the trend – performance improves as valuations fall.
The grey line shows the simple return (not including dividends) in the following two years. For example, the first data point on the grey line shows that the bank index fell 40.8 per cent between Dec. 29, 2006, and year-end 2008.(As an aside, I recognize that this makes the chart less easy to understand quickly. I think it's worth it – investors buying a stock based on valuations care most about future returns, not trailing performance.)
There is a clear correlation between bank price-to-book-value ratios and future returns. As price-to-book values rise, returns for the next 24 months fall (reminder – the valuation data are plotted inversely on the chart). The chart suggests that bank stock returns should remain positive for the foreseeable future as the grey line rises to meet the orange line.
The second, lower chart arises from an extensive report by Savita Subramanian, the chief quantitative strategist at Merrill Lynch. Ms. Subramanian's analysis found that forward price-to-earnings ratios are an even more effective method than price-to-book value for predicting the performance of global bank stocks.
The forward P/E ratio for the S&P/TSX bank index – price divided by the average analyst forecast for the next 12 months' earnings – is again plotted inversely to better show the trend. The grey line shows forward two-year simple returns for the bank index. The lines on the chart are closely aligned, signalling a strong relationship between forward P/E ratios and future bank-stock returns.
Like the first chart, the historical pattern suggests that sector performance will continue improving for the next 12 months.
However, investors can expect declining two-year returns beginning in December, 2017. Performance during that period will likely conform to the price-to-earnings line on the chart from January, 2015, to the present, where valuation levels bottomed and began rising.