Genuity Research teaches us how to trade the banks
Let’s face it. They are very much part of our lives. So it is with great appreciation that the Genuity Capital Markets equity research bank analyst has decided we all need to understand the basics of how we should trade the Canadian banking group. That is, if you think trading anything is a wise, long term move.
“Each rally brings forth calls that the recovery has started. Since the credit crisis began last summer, there have been three or four occasions when it appeared that the financials were beginning to recover from the credit crisis. In each instance, certain observers stated that the worst was over. The most recent rally (following WFC’s release of Q2/08 results) saw the Canadian banks rally 20% in six days (currently up 15%) and the U.S. banks rally 48% in six days (currently up 33%). This rally was also bolstered by the drop in oil prices, assurances from the U.S. Treasury regarding the GSEs, and a restriction on naked short trading of the largest financials.
Rallies following sharp price declines not evidence of improving fundamentals. BSC’s near failure, IndyMac’s failure, and concerns regarding the GSEs lead to sharp sell offs. In our view, the rallies that followed did not reflect evidence of an improving environment, but rather a belief that stocks had fallen enough to make it worth the risk. This last rally was particularly telling, as the financials rallied violently in the face of JPM’s warning about a deteriorating prime mortgage book. In our view, the only absolute evidence that investors should focus on to support the belief that the worst is over is price stability in the U.S. housing market. Until there is evidence that U.S. housing supplies are declining (that is, resale activity is catching up with the pace of foreclosures) such that price declines will shrink, the environment will be one of trading around extremes.
Trading around extremes. Our tool to gauge trading opportunities is the P/B to excess return framework, wherein the Canadian banks’ forward P/B is compared to the excess of ROEs over the 10-year government bond yield. Our analysis suggests that at a 20% discount or greater, the banks are cheap enough to support buying the group, particularly the underperformers CM and BMO. At a 10% or smaller discount, the model supports selling the group. There is less conviction in the calls between a 10% and 20% discount. At the current discount of 18% (15-20%), we advocate an “Add if underweight” and “Hold if overweight” strategy.”