The S&P/TSX bank index is lower by 7.6 per cent from the March 6 highs, thanks in large part to apocalyptic real estate scenarios, but the sector is not yet compellingly valued.
In May, 2016, Merrill Lynch equity and quantitative strategist Savita Subramanian published a massive, vital, 240-page report identifying the valuation methodology that works best for each individual market sector. (The resulting summary table, one of the most important documents I possess is posted on social media here.) Among the findings was that forward price-to-earnings ratios (the "earnings" part based on 12-month analyst consensus), not the more widely used price-to-book ratio, is the best predictor of bank stock performance.
The first chart below shows the ability of forward P/E ratios to predict two-year returns for the S&P/TSX bank index (I used the simple, not total-return index for data reasons). Each dot represents the forward P/E ratio and index returns for the following two years, for each week since May 4, 2007. The dot on the furthest left, for example, shows one instance where the forward P/E ratio of the bank index was 13.2, and the index fell 33.3 per cent in the 24 months afterwards. (As it happens, that data point is from May, 2007, but dates are not plotted on these types of graphs).
The downward sloping trend line indicates that historically, future returns have climbed as P/E ratios declined. The current P/E ratio of 11.9, slightly above the 10-year average of 11.3, indicates that if previous patterns hold investors can expect a cumulative predividend return in the 7-per-cent to 10-per-cent range to May, 2019. (This estimate is done by finding where 11.9 on the Y-axis meets the trend line, and then following that point down to where it meets the X-axis.)
The relationship between bank dividend yields and future returns is less robust than for forward P/E ratios, but it's important in an income-hungry environment. The second chart below compares the relative yield of the banks – the bank index dividend yield minus the S&P/TSX composite yield – to forward 24-month returns. The dot at the furthest right, for example (it's from Feb. 20, 2009, but again, dates are not plotted on scatter charts) shows that when the bank index yielded 3.75 per cent higher than the benchmark, the index jumped 131.8 per cent in the following two years.
The upward sloping line means that cumulative returns from the banks have improved as bank yields exceeded dividends from the broader TSX. The banks currently yield 1.0 per cent more than the S&P/TSX composite, a bit lower than the 10-year average of 1.2 per cent. Using the trend line, this suggests flat returns for the banks in the next two years.
There is an elephant in the room where domestic bank performance is concerned and the elephant's name is the Housing Bubble. Those, such as myself, that believe the major banks will escape major balance sheet damage in a real estate correction still have to account for the accompanying high levels of consumer debt the bubble has caused. Record levels of household debt will inevitably result in a deleveraging process that will see a broad slowdown in lending activity across the country.
For investors with anything like a five-year time horizon, betting against domestic bank stocks has never been a good idea. Nonetheless, despite recent price weakness the banks are not a compelling buying opportunity now in light of potential risks.
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Scott Barlow