Time to get greedy over Canadian bank stocks?

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Given the strong headwinds facing the Canadian economy right now and the sharp sell-off in bank stocks over the past few months, investors are no doubt wondering if they should approach the banking sector with fear or greed.

Try this hybrid approach: Fear that Canadian banks will struggle this year with slowing earnings growth, but get greedy over the prospect that valuations are looking attractive.

Bloomberg News pointed out that January marked the worst start to the year for Canadian bank stocks in 25 years: An index of eight commercial banks tumbled nearly 10 per cent during the month over concerns that the collapse in oil prices will affect the broader economy. From their highs in 2014, the stocks were down considerably more.

In a report released on Tuesday, Standard & Poor's analyst Lidia Parfeniuk warned that banks could be in for a bumpy ride this year, underscoring the market's concerns.

"A confluence of factors is testing Canadian banks in 2015," Ms. Parfeniuk said. "With falling oil prices taking their toll, Canada's economic outlook has become less certain."

Canadian consumers are already heavily indebted and house prices have surged, potentially amplifying any downturn, she said. While the banks' exposure to the struggling oil and gas sector averages just 2 per cent of total loans, the energy downturn will weigh on the economy in Western Canada as well as crimp bank revenue generated from capital markets activities.

That said, her outlook is hardly doom-and-gloom. She estimated that bank earnings and revenues will increase by mid-single digits (at best) in 2015, supported by domestic retail and commercial lending businesses; commercial and industrial loan growth will remain relatively strong.

Fitch Ratings offered a similarly cautious-but-not-gloomy outlook: "The downside risk to the Canadian consumer is growing as personal debt has increased to keep pace with home price growth," said Justin Fuller, senior director at the credit rating agency, in a note. "While we do not expect consumers or the housing market in Canada to face a hard landing at this juncture, bank earnings may still feel the pinch."

He added that the ratings outlook remains stable. Though earnings growth will probably slow with plodding consumer businesses, the banks have adequate capital ratios and their balance sheet liquidity and funding is strong.

The question is, how much of this caution has already been priced in to bank stocks? According to Brian Belski, chief investment strategist at BMO Nesbitt Burns, the answer is, A lot. (This is where the greed kicks in.)

"Certainly lower oil prices, slower domestic growth, and tighter interest margins warrant some downward revisions to estimates," Mr. Belski said in a note.

"However, we believe the negative sentiment around this sector is overdone, and renewed fears about Canadian housing are misplaced. From our perspective, although growth is likely to be slower for Financials this year, the sector remains near peak operating efficiency and now offers compelling relative value."

The sector certainly showed some life on Tuesday. The S&P/TSX commercial bank index jumped 2.8 per cent for its biggest one-day gain in more than three years. The gains followed a a near-20 per cent rally in the price of crude oil over the past four days.