Remember when Canadians were laughing at the large number of foreign investors who were short selling Canadian bank stocks and using the resulting funds to buy U.S. bank stocks? We should stop doing that – this two-sided bet on U.S. bank outperformance of domestic bank stocks has been extremely profitable for them.
Recent trends, however, imply that Canadian bank stocks may be about to play catch-up.
The first table highlights that, despite the strong recent performance of the domestic banking sector, short positions on the stocks are generally the same or larger than a year ago. Short positions as a percentage of the total stock float for Royal Bank of Canada are slightly higher than in February, 2016, while bets against Toronto-Dominion Bank, Canadian Imperial Bank of Commerce and National Bank of Canada stocks are largely the same. Short positions have been reduced over the previous year for Bank of Nova Scotia and Bank of Montreal.
The S&P/TSX Bank Index has jumped 43 per cent since February 8, 2016, so I expected when I started this that short positions would be greatly reduced. There's a good reason the shorts remain – the U.S. KBW Bank Index was even stronger, up 54 per cent for the same period. Dividends are not included in either case.
The second chart shows the effects of recent performance trends on a hypothetical $10,000 investment in each index beginning in February, 2014. The profitability of a two-sided trade in which an investor shorts Canadian banks, and then uses the proceeds to buy U.S. bank stocks, can be estimated by the distance between the two lines.
The $10,000 investments were almost exactly equal in value as of the end of June, 2016. From there, however, the investment in U.S. bank stocks left domestic bank prices in the dust. The S&P/TSX Bank Index position appreciated by $2,805 and the U.S. bank investment climbed by $6,091. Foreign exchange markets played a role as the U.S. dollar appreciated 2 per cent against the loonie during the period, boosting the U.S. bank stock values in Canadian dollar terms.
Analysts covering U.S. banks are signalling that the rally in the sector may have reached the "too far, too fast" stage and that the outlook is darkening, giving Canadian bank stocks a chance to catch up.
Bloomberg reports: "Among stocks from JPMorgan Chase & Co. to Citigroup Inc., downgrades have outnumbered upgrades by a margin of almost 2-to-1 since the election ... . The advance in share prices has pushed banks' implied cost of equity, or expected long-term return, to below 10 per cent, a level that's usually associated with negative share returns over the next six months, Citigroup's Keith Horowitz wrote in a Feb. 16 note."