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Loan losses for domestic banks are set to rise because of business shutdowns and low oil prices.

Chris Helgren/Reuters

BMO Capital Markets’ chief investment strategist Brian Belski sees a lucrative buying opportunity ahead for Canadian bank stocks. Market history makes his case compelling.

Loan losses for the banks are set to rise because of business shutdowns and low oil prices. Mr. Belski’s research shows that peaks in banks’ loan-loss provisioning – funds set aside to offset expected defaults and writedowns – have historically signalled periods of strong outperformance for the sector.

Importantly, the strategist points out that banks tend to “front load” loss provisions – which implies that their peak could occur as early as the current quarter.

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The accompanying chart compares the performance of domestic bank stocks and the extent of loan-loss provisions back to 1995 (maximum history available). The blue line is the S&P/TSX Bank Index and the purple line is the total loan-loss provisions for the five largest banks.

domestic bank stocks vs.

loan-loss provisions

S&P/TSX

Bank Index

Total loan-loss provisions:

Big Five Banks ($ billions)

4,000

$3.5

3,500

3.0

3,000

2.5

2,500

2.0

2,000

1.5

1,500

1.0

1,000

0.5

500

0

0.0

1995

2000

2005

2010

2015

2019

JOHN SOPINSKI/THE GLOBE AND MAIL

SOURCE: SCOTT BARLOW; BLOOMBERG

domestic bank stocks vs. loan-loss provisions

S&P/TSX Bank Index

Total loan-loss provisions:

Big Five Banks ($ billions)

4,000

$3.5

3,500

3.0

3,000

2.5

2,500

2.0

2,000

1.5

1,500

1.0

1,000

0.5

500

0

0.0

1995

2000

2005

2010

2015

2019

JOHN SOPINSKI/THE GLOBE AND MAIL

SOURCE: SCOTT BARLOW; BLOOMBERG

domestic bank stocks vs. loan-loss provisions

S&P/TSX Bank Index

Total loan-loss provisions:

Big Five Banks ($ billions)

4,000

$3.5

3,500

3.0

3,000

2.5

2,500

2.0

2,000

1.5

1,500

1.0

1,000

0.5

500

0

0.0

1995

2000

2005

2010

2015

2019

JOHN SOPINSKI/THE GLOBE AND MAIL, SOURCE: SCOTT BARLOW; BLOOMBERG

The first major peak in loan-loss provisions on the chart occurred in September, 2002. In the following 12 months, the bank index jumped 30.3 per cent, including dividends, outdistancing the S&P/TSX Composite return (not shown on chart) by almost eight percentage points.

The same trend of bank outperformance occurred after the second peak in provisions in June of 2009. The next year saw banks climb 16.6 per cent compared with the TSX’s 12-per-cent total return. Banks also outperformed after the smaller peak in provisions in June, 2016, with a 23.2-per-cent rise that beat the S&P/TSX Composite by 12 per cent to the end of June, 2017.

BMO’s trade idea – buy bank stocks when provisions peak – is extremely well supported by market history. The challenge for investors now is identifying when maximum loan-loss provisions are in place and set to decline.

We will begin to get some answers later this month. Bank of Nova Scotia and National Bank kick off the earnings reporting season for the sector on May 26; Royal Bank of Canada and Bank of Montreal announce quarterly results the next day.

Investors should be looking for big increases in provisions for losses as a potential sign that the major banks feel they have built enough of a buffer against potential virus- and energy-related defaults to weather the financial storm. A sharp rise in loss provisions – 30 per cent or more – would indicate the “front loading” Mr. Belski predicted, and a potential sign of peak provisioning.

Equity markets appear to be signalling better economic times ahead and crude prices have rallied from the lows. This raises the odds that peak provisions might be imminent. Once that point has been reached, it should provide an attractive entry point for domestic bank stocks.

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