The most positive argument for stocks is that there is no better alternative in this low-interest rate world.  But it also forces investors to go further out on the risk curve in order to earn a reasonable rate of return.  While the rally from the lows in February seemed to have been driven in large part by the substantial cash levels of average investors being drawn into stocks, the reality looks to be something different.  The chart below from Ned Davis Research shows that individual investors have been net buyers of stocks over the past six years taking stocks as a percentage of their portfolios from a low of under 35% to over 52% at the end of the first quarter of 2016.  This is well above the historical level of 44% and suggests that there is not really the ‘mountain of cash’ sitting on the side-lines waiting to come into stocks that many bullish strategists claim.

U.S. households invested in stocks

Canadian banks can’t seem to catch a break lately when it comes to investor sentiment.  Between worries about an overvalued housing market, deteriorating loans to the energy sector, high consumer debt levels and more competition from ‘fintech’, the banks have struggled to keep pace with the gains in stock prices over the past six months.  U.S. investors have taken this dissatisfaction with the outlook a step further as they have been active short-sellers of the Canadian banks for the last three years.   Clearly they are expecting our banking sector to go through the same pains that their banks did when the real estate bubble collapsed in 2008.  The chart below shows how the short position of Canadian banks on the New York Stock Exchange has risen from a level of about 35 million shares in 2013 to a peak earlier this year of over 100 million shares.  Of course, if the banks hold up better than expected, the ‘short squeeze’ that would occur as those positions have to be bought back would be sure to lead to some significant strength in bank stock performance!

U.S. investors still bearing on Canadian banks

One reason why U.S. investors are so negative on Canadian banks is that the U.S. banks have had such a bad period of underperformance and are trading at valuations that are far below historical norms.  This comes despite the fact that they all passed the most recent ‘stress tests’ which projected their capital levels under severe economic circumstances.  Unfortunately the latest round of results came out the same day as the Brexit vote.  Even after a rally last week, Bank of America, Citigroup, Morgan Stanley and Goldman Sachs Group are down an average of nearly 20% so far this year, while the S&P500 Index is up 3%. The KBW index of 24 large banks stocks has fallen 12%.  The depressed financial sector, including banks and asset managers, could represent one of the best values in the market.  However, banks get little credit for their financial health.  This is the opposite of 2006, when banks had strong earnings and weak balance sheets.  Now it’s weaker earnings and stronger balance sheets.  Major banks trade for an average of about 10 times estimated 2016 earnings, compared with a S&P500 Index price/earnings ratio of 17. The P/E of big banks is just 60% of the S&P500’s P/E; that is below the historical average of 75%.   Banks are also being held back by the fact that they have a tougher time in a very low interest rate environment since they tend to ‘borrow short’ (i.e. low deposit rates) and ‘lend long’ (mortgage and personal loans).  When all interest rates are so low, the ‘spread’ between rates compresses and this negatively impacts the profitability of their loan books.   All of that aside, we feel that both U.S. and Canadian banks still offer superior long-term return potential as well as healthy dividends.  With the recent passing of stress tests by U.S. banks, they will be in a better position to begin to increase dividends as well as initiate stock buybacks.  We have rarely seen bull markets in stocks that did not include leadership from the financial sector.  If this rally has any legs, then the banks will have to participate.  If we get a pullback in stocks, the strong capital levels, high dividend yields and low valuations should make the banks a safer haven than the resource or cyclical stocks.  Sounds like a ‘win-win’ scenario to us!

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