Foreign investors betting against Canadian bank stocks continue to swell in numbers while stock prices in the sector grind higher. The result, for now, is considerable financial pain for the doomsayers.
The short positions on Canadian banks have almost uniformly resulted in losses and this had me all ready to write a "foreigners don't understand the Canadian banking system" column. But I'm worried I'm missing something now.
The scale of short positions on domestic banks continues to increase despite the fact that they are extremely expensive to maintain. There's a borrowing cost – portfolio managers have to pay an ongoing fee to borrow the bank shares they're shorting – and the managers also have to cover the significant annual dividends paid by bank stocks. In addition, profit reports for the banks have been strong so far this earnings season. So why are the shorts so confident?
The first chart below uses Toronto-Dominion Bank as an example of what's happening throughout the sector. Short positions as a percentage of outstanding shares on TD stock surged in January, 2016, and continue to climb. For most banks, short interest is at record levels. Yet bank stocks have not only refused to go down, the S&P/TSX bank index (not shown in charts) is higher by 27.1 per cent, including dividends, since the January lows.
The early year concern for domestic bank stocks focused on energy industry exposure. The banks repeatedly stated, however, that potential losses were minimal as a percentage of total business operations and wouldn't affect earnings too much. With help from a partial recovery in the oil price, this has proven correct.
If oil losses were the main reason for the short positions, we'd expect the number of bearish bets on bank stocks to have decreased as the oil price recovered. This has not been the case.
Profits for Canadian banks have also been more reliant on capital markets activity – trading and investment banking operations – and in industry terms this is what's called a "lumpy" source of profits. Capital markets profits are inconsistent on even a quarter-over-quarter basis and can double or dry up with little notice. Perhaps part of the short thesis is that this profits generator will fade, but on its own such a scenario doesn't seem a big enough reason to short a bank.
One U.S. hedge fund manager I contacted who holds a short position on Canadian banks believes that transaction activity is about to decline significantly. They believe that corporate and household clients will repay loans early, thanks to low rates, and growth in new loans will be extremely slow. In this scenario, profits from the banks' basic business of lending will fall.
We've covered the energy sector, capital markets and credit demand, which leaves the domestic housing markets. National Bank economist Warren Lovely wrote in a report released on Tuesday that real estate markets have been "surprisingly sturdy" in recent years, but that "cracks in the foundation are nonetheless visible," notably in regions dependent on oil revenue. Vancouver housing sales, viewed as unstoppable until very recently, have cooled considerably as the Vancouver Sun reported that sales in the metro area have "frozen solid."
It has been fashionable for domestic pundits, including me, to write that foreign managers' short positions on Canadian banks were a negligent mistake because they did not understand the Canadian Mortgage and Housing Corp.'s role in protecting major banks from losses on mortgage defaults.
But too much time has passed for that to be the case, at least in general. The U.S. hedge fund companies that hold the bulk of the short positions have analysts looking deeply into every trade and I refuse to believe they don't understand the CMHC's role at this point. In the majority of cases, they make too much money to be that dense.
I've written at least three bullish columns on Canadian banks in recent months and still lean that way. But it's a bad idea for any investor to get so locked into a market view that they consider anyone betting the other way as stupid or uninformed. I won't be as comfortably bullish on domestic bank stocks until I have a clearer idea what the hedge funds are thinking.
Follow Scott Barlow on Twitter @SBarlow_ROB.