Wall Street bullishness on global financials has reached fever pitch after attractive valuations and rising interest rates drove the sector to strong performance in September. I applied this thesis to domestic bank stocks and found that, while there's no reason to be bearish, the bullish rationale does not apply.
Merrill Lynch derivatives strategist Nitin Saksena believes that U.S. financials represent a "striking opportunity" as sectors positively correlated to interest rates begin to outperform the broader market. In an Oct. 3 report, Citigroup Inc. strategist Chris Montagu notes that global bank stocks were among the best performing sectors in developed-world indexes. Mr. Montagu attributes these strong returns to a market that is now rewarding the banks' low valuation levels relative to history.
The banks' basic business of lending involves borrowing funds at short-term interest rates and lending the proceeds to clients at higher longer-term rates. The difference between the costs of borrowing and the monies received from customer payments makes up the bank profit where loans are concerned. As a result, it's not the nominal interest rates that drive bank earnings (and by extension stock prices), it's the difference between short- and long-term rates. This is measured by the steepness of the yield curve.
I compared the steepness of the Canadian yield curve (in a number of different variations) with forward bank-stocks performance and, in short, I found that if the yield curve was ever a good indicator for bank-stock returns, it isn't any more.
The closest relationship between the yield curve and bank-stock performance is depicted in the first chart below – the difference between two-year and 10-year bond yields, and the subsequent 24 month performance of the S&P/TSX bank index.
The available data go back to 2003. It looks very much like the yield curve was an effective indicator for bank-stock returns from 2003 to 2009, but afterward provided little or no useful guidance at all. In practical terms, the recent rise in domestic bond yields is not a good reason on its own to buy bank stocks, even if it should, in theory, be a positive driver.
Exhaustive analysis by Merrill Lynch chief quantitative strategist Savita Subramanian concluded that the best valuation metric for bank stocks – the one that best predicts future performance – is the price-to-earnings ratio relative to the historical average. Unfortunately, however, this technique doesn't work much better for Canadian bank stocks than the yield curve.
The second chart below shows the relative price-to-earnings ratio (trailing P/E divided by the 10-year average of 12.4 – the final reading of 0.4 per cent, for instance, means the current P/E ratio is 0.4 per cent higher than the 10-year average) and the subsequent 24-month return for the S&P/TSX bank index. Note that P/E ratios are plotted inversely to better show the trend.
The correlation is negative – future returns fall as bank stocks become more expensive – but the relationship is not strong at all. This implies that relative P/E ratios are an unreliable indicator of future returns for domestic banks.
The charts imply that the two biggest reasons for global bank-stock bullishness, rising bond yields and valuations, don't really apply to Canadian banks, and I know this is an unsatisfying conclusion. My guess is that our banking industry is so operationally diversified, with businesses far beyond basic lending, that they are less sensitive to interest-rate changes than their global counterparts. In terms of valuations, the domestic banks are so dominant that stock prices can be driven more by the economic environment than the attractiveness of valuation levels.
The fact that Canadian banks don't fit in to the broader bullish thesis doesn't mean the future isn't bright. It remains a fact that there has rarely been a bad time for longer-term investors to buy bank stocks, and just because they don't fit a broader pattern doesn't mean that anything has changed.
Scott Barlow, Globe Investor's in-house market strategist, writes exclusively for our subscribers at Inside the Market online.
Scott Barlow