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What happens to a TSX market rally driven by short covering in bank stocks when the short covering stops? We might be about to find out.

In a recent report, Canaccord Genuity portfolio strategist Martin Roberge argued that the recent rally in the S&P/TSX composite was mainly the result of short covering in the financial sector. Mr. Roberge warned that if market leadership doesn't broaden, with more stocks outside of the financial sector pushing the benchmark higher, the rally could stall.

Mr. Roberge's report included a remarkable chart showing a massive reduction in the number of S&P/TSX 60 member shares sold short since early 2016. From a high of one billion shares shorted in January, 2016 (a level he called unprecedented in a separate e-mail exchange), the number of shorted shares has been roughly cut in half. This includes a remarkable 35-per-cent month-over-month decline in total shares sold short between September and October this year.

The strategist also noted that rising financial stocks accounted for more than 50 per cent of the S&P/TSX 60's rally since the lows in September.

Short-selling Canadian banks stocks and using the proceeds to buy U.S. bank stocks has been a popular trade for foreign hedge funds for a number of years. The trade is designed to benefit from the prediction that U.S. banks (and the U.S. dollar, if the fund manager doesn't hedge the currency) will outperform their Canadian counterparts. In many cases, the hedge funds with this position are predicting the implosion of the domestic real estate rally and subsequent negative effects on Canadian credit markets.

The chart below depicts the scale of short positions for each major Canadian bank at four points in time. The dates correspond with industry peaks in the number of bank short positions as a percentage of the total stock float.

For most of the banks, the number of shares sold short is now equal to or below the levels of three years ago. This indicates that a large number of hedge funds previously betting against Canadian banks have covered their positions by buying shares in the market, helping lift stock prices. For Royal Bank, BMO and National Bank, shorts are much lower than at any point since 2014.

Using popular exchange-traded funds, the next chart shows the relative performance of $10,000 Canadian dollars invested in U.S. and Canadian banks over the past three years. Most of the funds betting against domestic bank stocks with short positions also carried a corresponding long position in U.S. banks, so relative performance is key.

The difference between the two lines represents the notional profit on the short-Canadian-banks-long-U.S.-banks trade (the value of the U.S. bank investment minus the cost of covering the short by buying domestic bank shares in the market).

The sharp recent reduction in short selling on domestic banks is most likely profit-taking by foreign hedge funds. The strong performance of U.S. bank stocks that began in early November, 2014, continues and the long/short trade remains extremely profitable – this means the hedge funds weren't forced out of their two-sided investment by market losses.

Investors will cheer any kind of market rally, but short covering rallies have implications for future performance. Short covering rallies have finite end points – once everyone's covered the short, the rally often stalls. In the case of Canadian bank stocks, the continued outperformance by U.S. banks could mean that, for now, short covering is almost complete and the domestic bank stock rally is ending.

As Mr. Roberge noted, recent gains in the S&P/TSX 60 were driven predominantly by bank and finance stocks and, if their prices stall out, declines in the broader benchmark become more likely.

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