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Despite stock market valuations suggesting the good times are rolling again, Canadian banks still face significant challenges that could put a damper on earnings down the road, said Dundee Securities Corp. analyst John Aiken.

"The banks remain overvalued," Mr. Aiken said in a note today.

He said:

The Canadian banks are still in an excellent position against almost all global comparisons, but cracks are beginning to form. Credit continues to deteriorate and trading revenues and securitization fees will be difficult to sustain at the lofty levels reported in the second quarter.

Since early March when the market was close to its lowest point this year, bank shares have jumped a whopping 63%, according to Mr. Aiken.

The remarkable performance suggests the market believes that the worst of the financial crisis is over and that the days of 20% returns on equity are not far off.

But in fact the underlying trends suggest this is not the case with loan losses set to spike and the meltdown in the U.S. economy showing no signs of abating.

"We are concerned about the lagging effect of economic weakness on corporate and commercial credit quality, which will mark the next stage in deterioration," Mr. Aiken said.

He advises that investors should shift their attention onto regional banks such as National Bank of Canada, Laurentian Bank (OTCPK:LRCDF) and Canadian Western Bank, which are less exposed to the problems the big banks are suffering from.

Source: Canada's Banks in Excellent Position, But Cracks Starting to Form - Dundee