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People pass by Bank of Montreal headquarters in Toronto on Tuesday, Aug. 28, 2012.Michelle Siu/The Canadian Press

Bank of Montreal stock opened higher Wednesday after the company reported quarterly results that, while accompanied by a dividend increase, also included a 3-per-cent year-over-year profit decline. This resilience could potentially spur a decline in the surprisingly large short positions on domestic banks.

Canadian investors have been consistently rewarded by their trust in domestic bank stocks, but in recent years global investors displayed a far more pessimistic view. Short positions on Canadian banks have ballooned across the sector, to record levels in some cases, as non-Canadian funds bet on major declines.

According to one major bank loan desk – the capital markets department that loans out shares to larger clients so they can sell them short – the pessimism is focused on global hedge funds "based on their perception of [Canada] being an oil country with a housing bubble and nothing else." It is also reasonable to assume that the bank shorts are also a bet against the loonie – a declining Canadian dollar would increase the profits for international investors (by making the short position cheaper to cover).

The first chart below shows the evolution of short positions on Bank of Montreal over the past decade. In February 2016, total BMO stocks shorted as a percentage of the total float hit a 10-year record of 4.0 per cent before falling back to 3.6 per cent at the end of April. Surprisingly, and this is true for all Canadian banks, the current total short positions are well above the levels of the financial crisis period.

The second chart shows the current short positions for the major banks versus their 10-year averages. Pessimism is particularly evident at Toronto-Dominion Bank, where 4.5 per cent of outstanding shares are shorted – more than double the 10-year average – and National Bank of Canada.

The funds betting against Canadian banks could still be vindicated, and there is certainly no shortage of pundits predicting housing market-related doom for domestic lenders. But so far, the domestic banks have been able to weather the storm of the commodity price declines, and regional real estate slumps.

This increases the likelihood that Canadian investors who hold bank stocks will be rewarded for their faith, once again. As the hedge funds that hold the short positions capitulate, they are required to buy shares to "flatten" or close out their trades.

This market term for this is a short squeeze. In this case it would involve the bank pessimists rushing to buy shares before they lose any more money on their shorts, driving bank stocks higher.

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