As Canadian bank shares soar, short-term investors beware

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Canadian banks' consistent profit growth and regular dividend increases have created a problem for investors: Bank stocks are now expensive after an impressive rebound from the sell-off earlier this year.

Royal Bank of Canada shares now trade at nearly 12 times trailing earnings, up from a price-to-earnings ratio that was below 10 earlier this year, after the share price rose more than 20 per cent since February.

Toronto-Dominion Bank shows a similar trend: The shares trade above 12 times trailing earnings, up from a P/E ratio that was below 11 earlier this year.

Admittedly, these stocks look cheap next to the broader market. The S&P/TSX composite index and the S&P 500 both have P/E ratios above 20.

But the banks – stable and slow-growing – tend not to hold on to hefty valuations for long, especially when the bond market is signalling slow economic growth and ongoing low interest rates.

John Aiken, an analyst at Barclays Capital, compared the banks' current P/E ratios with the spread between two-year and 10-year Government of Canada bonds, and concluded that bank stocks are likely to suffer in the medium term.

"Based on recent correlations, we believe that the recent lift in the Canadian banks' P/E multiples is unsustainable," Mr. Aiken said in a note.

The spread between two-year and 10-year bond yields is now less than half a percentage point, after falling from about one percentage point a year ago and 1.5 percentage points in 2013.

This is what's known as a flat yield curve, which is a headwind for banks because they borrow money (largely through deposits) at short-term rates, and lend money to consumers and businesses at longer-term rates. The difference is the net-interest margin, and it helps generate bank profits.

Since the yield curve is flat, though, the banks' net-interest margins are compressed, weighing on bank profitability.

More to the point, Mr. Aiken has tracked the historical correlation between bank stock valuations and the yield curve since the financial crisis, and has found that bank stocks tend to suffer when the two measures diverge.

On three previous occasions since 2009, when bank stock valuations rose and the yield curve flattened, bank valuations felt the pull of gravity, falling by an average of two P/E multiple points as share prices declined.

"On each occasion," Mr. Aiken explained in his note, "the multiples regressed after a moderate period of divergence." There is no reason to believe that today's divergence, the fourth since the financial crisis, will offer an exception, he suggested.

Long-term investors have been well served by holding on to bank stocks and ignoring advice to sell. Even if you had bought a Canadian bank stock on the eve of the financial crisis in 2007, you would be sitting on gains today of more than 80 per cent after factoring in dividends. That return dwarfs the 30-per-cent gain (again, after dividends) of the broader Canadian market.

However, a steep bank stock valuation does suggest that investors could be treated to a rocky ride in the near future, challenging them to hold on through the turbulence. As well, high valuations could deliver a tempting trading opportunity for existing investors who don't mind taking some short-term risks related to market timing – in other words, selling now in the hope of buying later at a bargain.

Bank stocks have enjoyed a good run in recent months, as the worst fears about the Canadian economy and the repercussions of low crude oil prices have eased.

Long-term investors will no doubt rejoice at the banks' seeming invincibility. Short-termers, though, might want to consider their next move.