Short positions on Canadian bank stocks ramped to record highs beginning in early 2015 after Merrill Lynch strategist Michael Hartnett listed "short Canadian banks, and buy U.S. bank stocks" among his top trading ideas. Pessimism on domestic bank stocks remains high, but at least the number of investors shorting them has, in most cases, levelled off.
There is also a sense that, with a longer-term perspective, shorting Canadian bank stocks was "fighting the last war" – the outperformance of U.S. banks was largely over just as short positions on domestic bank stocks starting climbing.
The first chart, below, shows the value of $10,000 Canadian dollars in each of the S&P/TSX bank index and the KBW bank index, which tracks the U.S. banking sector, beginning in October, 2011. The outperformance of U.S. banks has been remarkable. The $10,000 investment in U.S. banks would be worth $24,816 today where the S&P/TSX bank index investment would be worth a still-significant but much smaller $15,565.
The middle chart shows the same $10,000 investment beginning at the end of December, 2014, just as Merrill Lynch's suggestion began the increase in domestic bank shorts. To Mr. Hartnett's credit, his trade idea worked very well until December, 2015, (the grey line was well above the orange line, indicating U.S. bank outperformance). But, for the entire time period, the return of Canadian and U.S. banks has been almost identical – the hypothetical investment in the KBW index outperformed by a mere $970.
The final, bottom chart shows the evolution of major domestic bank short positions in the past two years. In every case, the short interest as a percentage of the total stock float has risen sharply higher since the end of 2014. In most cases – Royal Bank, Bank of Nova Scotia, Bank of Montreal and National Bank – the growth in short interest has levelled off during 2016. Toronto-Dominion Bank and CIBC, on the other hand, have continued to show sizable growth in pessimistic trades.
I should note that there's no way to know how many of the investors shorting domestic banks have used the proceeds to buy U.S. bank stocks. To the extent the two-sided trade is still popular – and I suspect it is or I wouldn't write about it so much – we can expect the short positions to decline in size because the performance differential between U.S. and Canadian banks has narrowed.
There are other mitigating circumstances, however. Strength has been apparent in U.S. housing markets in recent months while Canada's real estate market has arguably peaked. A housing slowdown might not cause a disaster on domestic bank balance sheets, but the outlook for credit and mortgage growth looks more positive for U.S. banks in the years ahead. This might explain the continued high short interest on domestic banks stocks.
Scott Barlow, Globe Investor's in-house market strategist, writes exclusively for our subscribers at Inside the Market online. Subscribe to Globe Unlimited here.