Here’s why Canadian bank stocks are attractive

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It's true that banks have been forced to put aside far more funds to protect against losses in the energy sector, but over all, it's getting more difficult to understand why global hedge funds maintain large short positions on Canadian banks. They are fairly valued based on forward earnings and extremely attractive based on relative yields.

The most recent data highlight extraordinarily large short positions on all domestic banks based on shares shorted as a percentage of the total float. In TD Bank's case, for instance, 4.6 per cent of total shares have been shorted relative to the 10-year average of less than 2 per cent.

The two accompanying charts below imply these short positions might be money-losing propositions. The first compares the value of the S&P/TSX bank index relative to its price-to-forward-estimated-earnings ratio.

In a recent report, Merrill Lynch quantitative strategist Savita Subramanian identified forward P/E ratios as the most effective valuation tool for bank stocks. In a March 16 column, I described how well this applies to Canadian bank stocks relative to the more conventionally used price-to-book-value ratio.

The chart shows that bank stocks are not expensive based on forward earnings, despite the recent rally in the sector. The current reading of 11.4 is well below pre-crisis levels and only marginally higher than the post-crisis average of 11.2 times forward earnings estimates. More importantly, it's also significantly lower than the 12.9 level that warned of a sharp downdraft in the bank index beginning in August, 2014.

The second chart is even more bullish for Canadian bank stocks, particularly in a period where so many investors are desperate for income. The chart shows the relative dividend yield of the S&P/TSX bank index – simply the dividend yield for the bank index minus the yield on the government of Canada 10-year bond yield – compared with the forward 24-month return on the bank index.

The lines on the chart track closely. This indicates that as bank dividends climb higher relative to bond yields, the performance of bank stocks also rises in the two years following. The pattern strongly implies that forward returns on Canadian banks stocks are set to improve significantly – the orange line should rise to follow the grey line that's already established.

There are no guarantees in investing and there's no doubt that high household debt levels, red-hot mortgage markets in Vancouver and Toronto, and continued financial pain in commodity industries creates more risks for bank stocks than usual.

The statistical evidence however, combined with the historical financial solidity of the domestic banking sector (abetted by help from the Bank of Canada and federal government when necessary) point to a promising outlook for Canadian bank stocks.