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Get ready for a large short-covering rally in Canadian banks Add to ...

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The relative merits of U.S. banks stocks versus domestic bank stocks is now an open question in the aftermath of the titans of Wall Street getting hammered Wednesday afternoon. The distinct possibility of a large short-covering rally in domestic bank stocks is now on the table.

At the beginning of 2015, Merrill Lynch chief investment strategist Michael Hartnett famously recommended that global investors sell Canadian banks short and use the proceeds to buy U.S. banks. It was his No. 2 trade idea for the year and, for a long while, it was phenomenally successful.

It is an unbreakable rule of investing that short positions can’t be held forever – the shares eventually have to be bought back. Buying shares to cover a short position has the same effect as any other kind of share buying – it drives the price higher. The recent performance of Canadian and U.S. bank stocks suggests that many investors holding short positions on the domestic banks are thinking hard about starting to cover now.

In addition, short covering rallies are notoriously intense. Once the tide of covering begins, the share price starts climbing rapidly, and this incentivizes other shorts to rush and close their position to limit losses. And with a record amount of shorts, we could see a rally of record proportions.

None of this, of course, is guaranteed to any extent. It depends on current equity and currency market trends continuing and domestic credit markets remaining stable.

The seeds, however, have been sown and a sharp, short covering rally in bank stocks would not be a huge surprise.

Follow Scott Barlow on Twitter @SBarlow_ROB.

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Follow on Twitter: @SBarlow_ROB

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