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Get ready for a large short-covering rally in Canadian banks

The relative merits of U.S. banks stocks versus domestic bank stocks is now an open question in the aftermath of the titans of Wall Street getting hammered Wednesday afternoon. The distinct possibility of a large short-covering rally in domestic bank stocks is now on the table.

At the beginning of 2015, Merrill Lynch chief investment strategist Michael Hartnett famously recommended that global investors sell Canadian banks short and use the proceeds to buy U.S. banks. It was his No. 2 trade idea for the year and, for a long while, it was phenomenally successful.

Much of the financial benefits from this trade have now been erased, highlighted by the 2.6-per-cent intraday sell-off in U.S. bank stocks Wednesday after the meeting of the Federal Open Market Committee.

At the same time, however, the short interest in Canadian bank stocks remains at record levels. At TD Bank, for instance, the number of stocks sold short is equal to 4.6 per cent of the total float. The average short position since 2002 (when the available data begin) is 1.6 per cent and this includes the financial-crisis period. TD is only one example – short positions in the sector are almost uniformly at unprecedented levels.

It is impossible to know how many global investors still have the sell-Canadian-banks-to-buy-U.S.-banks trade still in place. The high short positions on domestic stocks suggest many still do. Investors betting on the end of the Canadian housing bubble, and the bank balance-sheet stress that could result, are undoubtedly another factor driving the large short positions.

The accompanying chart shows that the once huge performance advantage enjoyed by U.S. banks has been all but erased, and it happened quickly. At the end of 2015, an investor who shorted $10,000 worth of the S&P/TSX bank index and bought the KBW bank index with the proceeds had earned a profit of $2,408, or 24 per cent (represented by the cash value difference between the two lines on the chart). That profit now stands at 4.3 per cent thanks to the loonie rally and better stock price performance.

It is an unbreakable rule of investing that short positions can't be held forever – the shares eventually have to be bought back. Buying shares to cover a short position has the same effect as any other kind of share buying – it drives the price higher. The recent performance of Canadian and U.S. bank stocks suggests that many investors holding short positions on the domestic banks are thinking hard about starting to cover now.

In addition, short covering rallies are notoriously intense. Once the tide of covering begins, the share price starts climbing rapidly, and this incentivizes other shorts to rush and close their position to limit losses. And with a record amount of shorts, we could see a rally of record proportions.

None of this, of course, is guaranteed to any extent. It depends on current equity and currency market trends continuing and domestic credit markets remaining stable.

The seeds, however, have been sown and a sharp, short covering rally in bank stocks would not be a huge surprise.

Follow Scott Barlow on Twitter @SBarlow_ROB.

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