Stated bluntly, Canadian bank stocks are now more attractive than at any time since March, 2009, by conventional valuation measures. If past performance patterns hold, substantial returns will be available to investors in the sector.
The first chart, below, strongly suggests that the recent weakness in domestic bank stocks is overdone relative to profit growth. The grey line on the chart shows the year-over-year change in earnings per share for the S&P/TSX bank index. The orange line shows the index's year-over-year percentage change.
Earnings growth, or lack of earnings growth, drives the value of equities over the long term. The lack of divergence in the chart – the two lines rarely move apart for long – supports this investing rule for domestic banks.
The past two years has seen much higher volatility in bank stocks than profit growth. From mid-2013, aggregate year-over-earnings growth in the sector has remained in a narrow band between 4 per cent and 10 per cent. Index returns for the sector, however, have swung wildly from a 27-per-cent appreciation in the 12 months ended June, 2014, to a 9.5-per-cent loss. The stability in earnings growth suggests that while the 27-per-cent rally was overly optimistic, the S&P/TSX bank index was significantly oversold at the end of 2015 after falling 8.5 per cent for the year.
To build the second, lower chart, I tested the ability of price-to-earnings and price-to-book-value ratios for the bank index to predict future sector performance for the following 12- and 18-month periods. Over the past decade, the closest relationship by far (backed by correlation calculations) was between price-to-book-value (P/BV) and forward 18-month returns for the sector.
The resulting chart is, if anything, more bullish than the first. (Note that the average P/BV for the S&P/TSX bank index is plotted inversely to better show the trend: A rising grey line indicates a falling P/BV ratio and more attractive valuation levels).
The lines depict the P/BV for the S&P/TSX bank index and the performance of the index in the 18 months following that point. For instance, the first data points for each line on the chart show that on Feb. 28, 2006, the index P/BV ratio was 2.8 times and that index return from Feb. 28, 2006, to Aug. 31, 2007 – the next 18 months – was 8.8 per cent. The pattern is clear; the lower the P/BV, the higher the returns for bank stocks.
Historical tendencies strongly suggest that returns in the bank sector are set to improve – the orange line should rise to follow the declining P/BV (remembering that P/BV is plotted inversely on the chart).
As always, the market offers no guarantees and the historical relationship between performance and valuations may change. Recent weak bank stock returns, combined with the large short positions I've written about previously, indicate that investors are concerned that the end of the commodity bubble, low interest rates and the potential for a housing slowdown, will limit bank profitability in the future.
All tangible information, however, indicates that these fears are overdone and banks stocks are currently highly attractive.
Follow Scott Barlow on Twitter @SBarlow_ROB.