Merrill Lynch U.S. strategist Michael Hartnett recommended a strategy of shorting Canadian bank stocks and using the proceeds to buy U.S. banks at the end of 2014. Thanks mainly to the flagging loonie, the trade was extremely lucrative for investors who acted on his advice. Until recently.
U.S. bank stocks, as measured by the KBW bank index, have taken a beating in recent weeks and their performance gap relative to Canadian banks has declined significantly. As a result, there is a distinct possibility that short positions on Canadian banks will be flattened – the shares repurchased in the market – and domestic bank stocks rally significantly. If so, the primary beneficiary is likely to be Bank of Nova Scotia.
The accompanying chart illustrates the value of $10,000 invested in each of the KBW bank index and S&P/TSX bank index at the beginning of 2015 when Mr. Hartnett advocated the strategy.
The profit on the short-Canadian-banks-and-buy-U.S. trade is measured by the space between the two lines on the chart (the return on the U.S. bank investment minus the cost of buying back the short-sold Canadian bank position).
The maximum profit would have been made on July 22 at $2,807 (the U.S. stock position would have been worth $12,143 and the Canadian bank position would have cost $9,336 to buy back) or 28 per cent – not bad for less than eight months. Investors that took profits on Dec. 16 – the day the Federal Reserve raised interest rates, the profit would have been only marginally less at $2,758.
Since mid-December, Canadian bank stocks have outperformed U.S. banks – remaining relatively stable while U.S. bank stocks declined – and the profit on the hypothetical trade has been cut by half.
It is almost certain that many of the investors who followed Mr. Hartnett's trade idea – and the sharp increase in short positions on Canadian bank stocks suggests there were plenty who did – are getting nervous about protecting existing gains and are set to unwind the trade. This process involves buying Canadian bank stocks and a jump in Canadian bank stock prices would inevitably follow.
Bank of Nova Scotia has the largest short interest at 4.8 per cent of existing shares – this is likely because of their exposure to weak emerging market economies. This means that Bank of Nova Scotia stock would benefit most from a short-covering rally.
Expectations of a short-covering rally are not, on their own, enough reason to invest in BNS or any other bank stock. The usual course for short-covering rallies is a sharp upsurge in stock price, followed by a fall back that retraces some gains. But for those investors considering adding to holdings in the sector, and who have completed the requisite fundamental research, now could be an excellent time to pounce.
Follow Scott Barlow on Twitter @SBarlow_ROB.