There have been talks about rising short interest in Canadian banks.
The article from Financial Times titled The Big Short's Steve Eisman raises bets against Canadian banks published in March 2019, stated:
...collective wagers against Canadian banks have risen 19% since the start of the year to positions worth US$12.3 billion...
Steve Eisman was one of the smart guys who made a lot of money from the implosion of the subprime mortgage market during the financial crisis about 10 years ago in the United States.
So, the headline with Eisman's name in it surely catches investors' attention. That said, Eisman did not disclose which bank(s) he's shorting nor the extent he's shorting. However, he did point out that he doesn't expect something as severe as what happened 10 years ago in the U.S. to happen in Canada. In other words, he's not calling for a housing market collapse in Canada.
Is There a Housing Bubble in Canada?
One big concern is that property prices have increased much faster than income growth. As a result, in major Canadian cities, owning a home takes away a huge chunk from the household income. According to the research from Royal Bank of Canada (RY, TSX:RY), the housing affordability in Canada has improved slightly in Q4 2018 but is still asking for more than half of Canadians' income to cover for home-owning costs. That's +20% more than what the Canada Mortgage and Housing Corporation ("CMHC") defines as affordable. Specifically, the CMHC defines housing as affordable when a household spends less than 30% of its gross income.
Nation-wide, the share of income needed to cover the costs of owning a home fell 0.7 percentage points to 51.9%. (Source: RBC research - pdf)
Source: RBC research - March 2019
Not surprisingly, Vancouver and Toronto are the most expensive housing markets in Canada. The population in the two major cities make up about 10% of the Canadian population. Across the country, the average cost of owning a home is about 52% of median household income.
So, it could be a problem for the Canadian banks if an increasing number of homeowners in these cities (or anywhere else in Canada for that matter) stopped making mortgage payments. If Canada were to experience a recession, there would be a rise in job losses and the unemployment rate that can cause an increasing number of homeowners to stop making mortgage payments.
RBC showed that the single-detached home affordability has hit the historical low that last occurred around 1990. This time around though, the lower affordability has occurred less abruptly. So, it's also likely that we'll see a milder curve heading down or stagnation over the next few years versus the upside down "V" that occurred around 1990.
Source: RBC research - March 2019
RBC's conclusion in March 2019 was this:
We now expect home prices to be flat at best overall in Canada this year-with further price declines likely in Vancouver and Alberta. With household income still set to rise, the outlook for affordability has brightened somewhat.
RBC expects price declines in Vancouver because it is the most expensive housing market in Canada and Alberta because of the province's reliance on the energy sector, which has largely been down in the dumps. You can get an idea by looking at long-term stock price charts of oil and gas producers such as Crescent Point Energy (CPG, TSX:CPG) and Baytex Energy (BTE, TSX:BTE), which have lost substantial value, though the recent recovery in oil prices should somewhat help the situation in Alberta.
The Short Interest in the Big 5 is Actually Not That High
Observing over the last 10 years, the short interest is actually not that high across the Big 5 Canadian banks, Royal Bank, Toronto-Dominion Bank (TD, TSX:TD), Bank of Nova Scotia (BNS, TSX:BNS), Bank of Montreal (BMO, TSX:BMO), and Canadian Imperial Bank of Commerce (CM, TSX:CM).
There was much higher short interest in the Big 5 Canadian banks for the most part of 2016 and in early 2017. If anything, Canada's fifth-largest bank, CIBC, is the only bank that has short interest on par with the 2016 levels.
Valuations of the Big 5 Banks
In 2016, when the Big 5 Banks had the highest short interest:
- Royal Bank traded at a P/E of 10.3-13.1
- TD Bank traded at a P/E of 11.2-13.3
- Scotiabank traded at a P/E of 9.4-12.2
- BMO traded at a P/E of 10.4-12.7
- CIBC traded at a P/E of 9.3-10.6
- at about CAD$103 per share, Royal Bank trades at a P/E of about 12
- at about CAD$73.70 per share, TD Bank trades at a P/E of about 11.3
- at about CAD$71 per share, Scotiabank trades at a P/E of about 10
- at about CAD$102 per share, BMO trades at a P/E of about 11
- at about CAD$109 per share, CIBC trades at a P/E of about 8.9
The Big 5 banks are all trading within their 2016 valuation ranges, except for CIBC, which is trading at lower levels.
Should CIBC Shareholders Be Worried?
[CIBC] is essentially a play on the Canadian domestic market, which represents two-thirds of its business, versus an average of 40% for its peers. For this reason as well, CIBC ... has tended to trade at lower multiples than its Big Five peers over time. (Source: John Lawlor's article - Canada's Big 5 Banks Today: 3 Buys And 2 Holds)
CIBC is the most domestically exposed compared to the other Big 5 banks. Therefore, it will also be hit the hardest should there be stagnation or decline in Canada's housing market.
If we were a CIBC shareholder, depending on how big our position is, we'd either be holding onto our shares (but not adding more) or selling shares and investing in the other big banks which have less domestic exposure.
Should You Sell Your Big Canadian Bank Shares?
Should you sell your bank shares? The short answer is "no" unless you own CIBC stock and are worried about the health of the housing market. Royal Bank has the least short interest, which indicates investors are finding it to be the safest bank perhaps because the bank is the leader and largest among the Big 5 and also has a focus on high net worth clients.
Here's a longer answer to the question. Ultimately, investors should answer these questions for themselves and then make a decision on whether to buy/hold/sell accordingly:
- Why did you buy the big banks in the first place? What's your goal?
- What's your allocation in the Canadian banks or each bank?
- What's your investment horizon?
Here's our answer with regards to our situation:
- Currently, we own both TD Bank and Scotiabank. We bought the stocks when they were fairly or undervalued for stable dividends and growing income. We believe that at the places we bought the stocks at, that over the long term, we should get an annual total return of +10%. A large chunk of the returns come from their dividends and obviously, we've got to hold onto the shares to get the increasing dividends.
- The banks together make up only about 3.5% of our portfolio. So, we're actually very underweight in the banks and would appreciate holding a bigger allocation.
- We believe the big Canadian banks offer safe dividends. After all, they've paid dividends for a long, long time. For example, Scotiabank has paid dividends since 1832, and it has increased the dividend for the last 45 years, except freezing it in fiscal 2010. So, we're happy to keep them in our Conservative Dividend Portfolio. Their dividend safety is protected by stable earnings generation and a payout ratio that's typically below 50%, which offers ample margin of safety.
Some folks, who have held the banks for decades, might have an allocation of 20-50% in their portfolios. If that's the case, they should review the positions and determine if it's appropriate to take partial profit to reduce exposure and diversify elsewhere, especially if they own CIBC.
Reviewing history, the Big 5 Canadian banks actually don't have a high short interest, except for CIBC. The Big 5 Canadian banks are some of the most profitable businesses on the Toronto Stock Exchange.
For long-term investors who are looking for stable dividends and stable growth, it does not make sense to sell your stakes in the banks, unless you have a huge allocation, own a large stake in CIBC, or are worried about the health of the housing market in Canada. You've got to hold the stock to get the dividends!
We believe there's a higher probability of slower growth or stagnant growth in the housing market than a meltdown.
Share your thoughts below!
- What are your takes in the health of the Canadian housing market?
- How comfortable are you with your Canadian bank holdings and allocations?
- Which Big 5 Canadian banks are your favourite?
Disclosure: I am/we are long BTE, BNS, TD. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Disclaimer: This article consists of my opinions and is for educational purposes only. Please do your own research and due diligence and consult a financial advisor and or tax professional if necessary before making any investment decisions.