Monday, September 25, 2006

Banks Outperform the Market in Q4

BMO Capital Markets, 25 September 2006

Seasonality is one of the more compelling concepts in investment strategy, for more than just its simplicity. Theories that attempt to explain changes in stock prices not attributable to fundamental operating activities can resonate well with investors, particularly in between earnings seasons.

It is in the spirit of seasonality that we are releasing an updated version of our report discussing the patterns of Canadian bank stock performance relative to the TSX (first released in October 2004). In the original report, we considered Canadian banks stock performance relative to the market in each of the four calendar quarters over four decades. We found that bank share returns appear to have a seasonal component to them and tend to outperform the market in the fourth calendar quarter.

Sunshine in the Fourth Quarter

In examining the performance of the Canadian bank group relative to the TSX, we found that the incidence of outperformance was meaningfully higher in the fourth calendar quarter. Since 1960, banks have outperformed the market in the fourth quarter about 70% of the time—meaningfully higher than the incidences of outperformance in the other three quarters (Chart 1).

In addition, the extent to which banks outperform the market in the fourth quarter appears to be meaningful (Chart 2). Over the past 45 years, the average scale of outperformance by the banks relative to the market has been meaningfully higher in the fourth quarter than in the other three. Banks, on average, have outperformed the market by just over 3% in the fourth quarters, compared to under 1% in the second and third quarters, and actually underperforming the market in the first quarters.

The prospect of average outperformance of 3% is of course attractive but is also, by our own admission, only half of the story. A word on volatility is certainly warranted. In our examination of the standard deviation of bank returns across the quarters, we found that the variation did not change materially from one quarter to the next (Table 1). The volatility of returns of the banks relative to the market over the past 45 years has been roughly 6% across all four quarters.

Meteorology Anyone? Trying to Justify this Phenomenon

We conclude from the analysis above that, over time, we would expect banks to produce meaningfully higher returns compared to the market in the fourth calendar quarters. Furthermore, this outperformance should be achieved without a corresponding increase in volatility. Justifying why this occurs, however, is a more difficult task. To this, we offer a couple of suggestions.

First, from the perspective of a money manager, the last quarter of the year is equivalent to the home stretch of a race, with performance typically measured on an annual basis to December 31. This period tends to be one characterized as a time when managers shy away from taking risks, for fear of jeopardizing their annual performance record. Banks, because of their defensive nature, are often popular to managers looking for higher predictability of returns to sustain them until the end the year.

It is interesting to note that this reasoning can similarly be used to explain bank underperformance in the first quarters (Charts 1 and 2). Investors, with a full year ahead of them, tend to be willing to take greater risks comforted by the knowledge that there will be time to correct any missteps.

Second, we believe it is meaningful that bank earnings are reported on an atypical schedule with their fiscal year-end falling on October 31—two months ahead of the majority of organizations on the TSX. Typically, as year-ends approach, earnings estimates for the upcoming year are published, giving investors insight into analysts’ expectations of company strategy and growth. Because ‘next year’s’ earnings estimates are published earlier for the banks than for other stocks, we believe they benefit from this ‘sneak-peak’ phenomenon. Investors are exposed to the generally more attractive P/Es on growing earnings earlier than for other companies. We must point out that these ‘sneak peaks’ are, of course, merely psychological, as they predict only 10 months into the next calendar year. Nevertheless, we believe it can skew investor perception.

The Summer is Getting Longer and Hotter

It is interesting to note that, over time, the trends in bank seasonal performance have become more pervasive. Both the incidence and the scale of bank outperformance relative to the market have increased since the mid-1960s (Tables 2 and 3). In the decade ending 1975, banks outperformed the market in the fourth quarter half of the time. By the decade ending 2005, however, banks were outperforming 70% of the time. The trends in the scale of outperformance are very similar: between 1966 and 1975, banks outperformed the market in the fourth quarter by roughly 1.7%, but between 1996 and 2005, banks were outperforming the market by 4.6%.

Shelter in the Storms

It is all well and good to say that banks tend to outperform the market in the fourth quarters. In order to provide well-rounded research, however, we thought it important to examine the incidences in which this trend did not appear to hold true—in order to gain insight into what this might mean to our overall analysis.

In the 40 years between 1966 and 2005, banks underperformed the market in the fourth quarter a total of 12 times. We decided to investigate these incidences in two ways; first, from a rearview mirror perspective (examining the first three quarters to determine if performance in these nine months was correlated to performance in the last three). Second, we analyzed each incidence from the perspective of the overarching economic environment (examining the operating environment of the quarter to try to determine the factors that might have led to the underperformance).

With regard to our examination of the first three quarters of the year, we found that there was no meaningful correlation. Bank performance in the last quarter did not seem to depend on performance in the three quarters preceding. In the 12 underperforming quarters, the incidence of underperformance in the first nine months was exactly equal to the incidence of outperformance.

In investigating the macroeconomic environment of the individual fourth quarters in which the banks underperformed, we attempted to determine what the context of underperformance was. In other words, in the 12 quarters of relative underperformance, what happened to investors’ banks shares? Did investors actually see negative returns? Were their returns roughly flat? Or was it simply that the market performed unusually well, thereby outperforming relative to banks.

In our analysis of each of the 12 quarters (Table 4), we determined that there were three broad circumstances:

• First, there was the circumstance we see in the latter part of the study (1999–2003) where the market saw remarkably strong gains while banks performed somewhat more modestly. We view this situation as the least threatening. Given the defensive nature of bank stocks, it is reasonable to assume that they would not perform as well during particularly bullish periods.

• Second, there is the circumstance in which we saw the market realize modestly positive returns while the banks remain largely flat or slightly positive (years 1970, 1972 and 1988). These situations cause us slightly more concern than the first, but we remain comforted by the fact that bank investors were not losing any money; they were simply performing slightly less well than the market overall. Having said that, we note that a ‘rip roaring rally’ in equities (due to stronger oil or gold prices) would likely see bank shares lag materially.

• Finally, there is the circumstance in which we see the banks realizing negative returns. This situation is most alarming to us for obvious reasons. Through further investigation, however, we determined that of the five quarters in which this occurred, there were only two quarters where banks lost more than 1%. These were the fourth quarters of 1975 and 1976.

In these two quarters, banks meaningfully underperformed the market as well as realized signifi cantly negative returns. In examining the macroeconomic environment underlying these two years, we investigated long-term interest rates, oil shocks, gold rallies and the slope of the yield curve. None of these variables gave us any illuminating reason for the material bank underperformance.

Our interpretation of the situation during this period is the turbulence experienced in Quebec surrounding the election of the Parti Quebecois and the looming referendum. During this divisive period, Canadian companies, particularly those with significant exposure to Quebec consumers, saw their share prices heavily impacted. The oil shock of the mid 1970s also appeared to weigh on bank stocks.

The Farmer’s Almanac

If history plays any part in foretelling the future, we can expect that bank stocks should outperform the market in the fourth quarters. Moreover, in the periods in which this does not occur, assuming the market grows at a reasonable rate, investors are unlikely to see meaningful underperformance.

We believe energy prices and energy stocks pose the major risk to bank relative share price performance. With energy shares making up roughly 30% of the market, and with a meaningful correction in oil prices now possibly behind us, this is the one group that could cause banks to lag the market meaningfully. A significant back-up in long rates would also be an issue, but this appears unlikely.

On a year-to-date basis, the bank index has outperformed the market by a resounding 9%. We continue to rate the Canadian bank sector Outperform. Domestic retail earnings continue to see strong results, loan losses have remained obstinately low and opportunities for growth and diversification continue to emerge.