26 October 2009

Where Do Bank Stocks Go From Here?

Financial Post, John Greenwood, 26 Octber 2009

Like their peers around the world, Canadian banks got clobbered on stock markets as the financial crisis raged. But as the gloom cleared, their shares -- unlike those of many foreign banks that had the misfortune of owning toxic credit investments -- rocketed skyward, leading the way in one of the most spectacular stock market rallies in decades.

By early August, they had regained nearly all the ground lost since the storm broke in September 2008, collectively rising about 65% from the lows of March.

But for nearly three months since then, bank shares have mostly treaded water -- the sole exception Royal Bank of Canada, which peaked at the end of August instead of the beginning. As the broader Toronto market ploughed ahead, investors have been left wondering if that's all there is for the bank rally.

Brad Smith, an analyst at Blackmont Capital Inc., said he's not surprised.

"More than anything else, what you are seeing is a natural period of consolidation that you would expect to occur after a significant advance driven by improved earnings multiples going forward," said Mr. Smith. "So it's not surprising we are seeing this temporary lull."

Shares in Royal Bank last week closed at $53.39, down 59¢. Bank of Montreal ended at $52.03, down $1.01. Canadian Imperial Bank of Commerce was $1.09 lower at $64.36. Toronto-Dominion Bank was down 67¢ at $64.97, while Bank of Nova Scotia finished at $46.34, down 53¢.

Mr. Smith said the market is still trying to decide if the early optimism around the Canadian banks and their lack of exposure to subprime mortgages justifies the spectacular rise in shares, arguing that the upcoming forth-quarter earnings --due in early November -- will provide a lot of the answers.

One concern is that much of the good news that analysts are expecting has already been factored into the shares, so unless the results include some positive surprises, it could be bad news for investors.

"The banks are trading at roughly 13 times expected 2010 earnings but the reality is that, historically, the range is between eight and 15 times earnings, so we are much closer to peak multiple levels than troughs," said Mr. Smith.

Another issue that will likely affect the banks is proposed new regulations that have come out of Group of 20 nations discussions. In recent weeks, the focus has been on executive bonuses but the rules are expected to cover everything from how much capital banks are required to hold to the amount of leverage they can take on.

"These are the kinds of things that really do affect profitability," said an analyst who asked not to be identified. "No one knows [what the regulations will ultimately look like], so until you get some clarification you just have to hold your breath."

For its part, the federal government has argued that since banks in this country didn't get mixed up in the kind of toxic investments and reckless risk-taking that brought down so many of their global peers, Canadian regulations aren't in need of the kind of overhaul they're getting in the United States and Europe.

But critics say that unless Ottawa follows suit with its fellow G20 countries, it risks upsetting the global balance and becoming a magnet for foreign firms that want to sidestep the rules in their home jurisdictions.

"Capital markets is a global business," said Mr. Smith. "You can't have pockets of regulation that are different from the rest because all the capital will tilt into those jurisdictions."

Another explanation for why bank shares haven't moved is that investment dollars are being drawn toward more attractive sectors such as energy.

At a time when there is so much uncertainty over financial services, the logic around oil and gas is simple. Against the backdrop of an improving global economy, oil prices have been moving steadily higher over the past few months.

"At the end of the day, a guy pulling oil out of the ground [in today's economy] has less risk than a guy sitting on a bunch of loans."