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After lagging the market during the recent rebound, bank stocks are now catching up with big gains of their own. What will it take to keep the rally going?

In the United States, the S&P 500 began the week down just 3 per cent for 2020 – a head-spinning performance given the backdrop of surging unemployment, plummeting corporate profits and a shocking downturn in economic activity.

U.S. commercial banks, though, appear to reflect the grim reality: Though off their lows, the stocks are down about 30 per cent for the year.

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The Canadian picture isn’t quite as stark, though it reveals a similar disparity between banks and the broader market. The S&P/TSX Composite Index is down 8.7 per cent so far this year, while the Big Six banks are down about 15 per cent, on average.

But things are starting to shift as bank stocks come to life. Royal Bank of Canada has rallied 14.5 per cent since May 26, when the big banks began to report their second-quarter financial results. That has easily beaten the 3-per-cent gain by the TSX over the same period.

The KBW Bank Index, which tracks 24 U.S. banks including Bank of America, JPMorgan Chase & Co. and Citigroup, has surged more than 28 per cent during a broad market rally that began in mid-May. That is nearly triple the 10-per-cent gain for the S&P 500 over the same period, and surely suggests investors are gaining confidence in an economic rebound.

Feel like joining the rally?

The attractive aspect here is that most bank stocks have a lot of room to rise before they fully recover. Bank of Montreal, for example, would have to rise another 42 per cent to hit a new 52-week high.

Also, valuations are low: The Big Six stocks trade at just 9.3 times estimated 2021 earnings, according to Darko Mihelic, an analyst at RBC Dominion Securities. That is well below the 10-year average of 11 times earnings and close to the sector’s cheapest valuation since the financial crisis.

And let’s not forget about those big dividends: The average yield is now 5.3 per cent. That’s higher than any time since the financial crisis (other than earlier this year, before the recovery began) and it’s a huge payout relative to the 0.675-per-cent yield on the 10-year Government of Canada bond.

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But, clearly, any bet on bank stocks rests on a number of optimistic assumptions about the economy – and the banks’ exposure to it.

Loan losses are key here. The Big Six set aside a collective total of $11-billion in their fiscal second quarter, ended April 30, to cover bad loans. These provisions drove down their profits by 50 per cent, year-over-year.

Is the worst behind them? Perhaps: Banks that booked the most provisions relative to their loan books (RBC and National Bank of Canada) have been rewarded with sector-beating share price gains, suggesting that some investors believe that provisions are set to decline in the quarters ahead.

But analysts aren’t so sure about this. Gabriel Dechaine, an analyst at National Bank Financial, argued that confidence in declining provisions for loan losses rests on improving economic data and big reductions to the total amount of loans whose payments have been deferred by the banks, in order to give customers more time to make their payments. That amount has soared to more than $300-billion or 11 per cent of total Big Six loans.

“These factors depend highly on the pace of economic recovery,” Mr. Dechaine said in a note.

Douglas Porter, chief economist at BMO Nesbitt Burns, said in a note last week that the road to recovery could be an exceptionally long one.

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“The single biggest reason why it will take so long to get back to 100 per cent is simply the massive hole that has been dug,” Mr. Porter said in his note.

That’s not good news for bank stocks.

Full disclosure: The author owns units of an exchange-traded fund that tracks the Big Six banks.

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