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scott barlow

Bank of Montreal chief investment strategist Brian Belski believes the negativity surrounding Canadian bank stocks is way overdone and provides further statistical evidence for a bullish outlook on the sector.

Mr. Belski reiterated his overweight recommendation on Canadian bank stocks in his most recent review of domestic markets sectors. He noted that valuations remain attractive relative to historical averages despite the recent rally and that "fears surrounding the sector are greatly exaggerated."

More importantly, Mr. Belski argues that the primary reason for weaker bank profits in recent quarters – provisioning for loan losses – has now peaked. Historically, bank stocks have outperformed the general market as provisions decline.

The chart below compares total loan-loss provisions for Canadian banks with the Merrill Lynch option-adjusted corporate bond spread index for Canada. The Merrill Lynch index measures the yield of the average domestic corporate bond relative to government bonds. For instance, a reading of four indicates that the average corporate bond yields 4 per cent more than a similar government bond.

Bank loan-loss provisions follow corporate spreads closely. Higher yields on corporate bonds indicate higher default risk – investors require higher coupon payments to compensate for added risk. It makes sense that bank loan-loss provisions also rise with default risk as lenders protect their balance sheets from potential bankruptcies.

For Mr. Belski, the recent decline in the Merrill Lynch index (the grey line) represents falling default risk and as a result, banks will be putting fewer earnings aside for potential loan losses, and profit growth will benefit.

If loan-loss provisions have peaked, this is great news for investors in Canadian bank stocks. The last two time periods when provisions fell, the market returns were dramatic. Between August, 2002, and February, 2007, the S&P/TSX bank total return index generated an average annual profit of 21.0 per cent, well above the S&P/TSX composite's 18.6 per cent.

In the wake of the financial crisis, banks again provided strong returns. The bank index climbed at an annualized pace of 40.9 per cent from March, 2009, when loss provisions peaked, to February, 2011, when they began rising again. The S&P/TSX composite climbed at a 32.6 per cent annualized pace during the same period.

Credit spreads and bank loan-loss provisions are not, at this point, anywhere near the stretched levels of 2002 or 2009 so bank stock outperformance is likely to be less dramatic than previously. Still, outperformance is always welcome for investors even if it's not by much.

The bank-related fear Mr. Belski believes is exaggerated is not completely unwarranted, in light of the ongoing slump in resource industries and the potential for a housing market correction. There is more investment risk in the sector than many Canadians are used to. But this is the third time I've detailed reasons for an optimistic outlook for banks in the past month, previously noting the potential for a short covering rally, and the significant yield advantage bank stocks maintain over bonds.

Despite the risks, the reasons for adding more domestic bank stocks are piling up.