Canadian Banks: Is Now The Time To Get Out While You Still Can?

Includes: BMO, BNS, CM, RY, TD
by: Stock Jackal

The "Big 5" Canadian Banks Royal Bank (NYSE:RY), Bank of Nova Scotia (NYSE:BNS), Bank of Montreal (NYSE:BMO), Toronto Dominion (NYSE:TD), and Canadian Imperial Bank of Commerce (NYSE:CM), have historically been a steadfast investment for the growth, conservative, and income (dividend) type investor.

The purpose of this article is to be a cautionary one, and to propose that the steadfast status quo of the 5 banks may be at risk of changing. The focus of this caution is mainly for the growth and conservative type investors. A potential issue that exists with the Canadian banks is that capital appreciation in the short-term may be over with. However, on the bright side, the big 5 may still remain a good income play. This article will detail a case on why growth and conservative investors should be wary of holding long positions.

A recent article in the national Canadian newspaper the Globe and Mail basically underlines the issues that face the Canadian banks. The highlight of this article is that economic headwinds pose risk for the banks. Furthermore, there is caution to be observed in that recent earnings may not be as consistent, or as stellar on a go forward basis.

There is also the warning and possibility of an over supplied Canadian housing market in some major metropolitan areas of Canada. This is graphically demonstrated on the chart below (high rise buildings under construction). It does not take an economist to see that there is a huge supply disparity on the chart. The reader will note that Toronto's supply is substantially higher than that of NYC, Chicago, and Mexico City.

An important variable to consider is that even though Toronto is Canada's largest city, it is dwarfed in population size to the former cites mentioned. Furthermore Calgary, Mississauga (part of GTA), and Vancouver are all Canadian cites, and shown on the chart as well. An additional consideration could be that Chinese foreign investors have propped up the Vancouver real estate market. This is important, because If there is a subsequent economic slowdown in China, some of these Chinese investors may be forced to liquidate their "Canadian cottages" or investment properties in Canada.

Any one of these possible events could put downward pressure on Canadian home prices, which does not bode well for the 5 banks in general. As a refresher on recent events, readers will remember what happened in the U.S., and other countries to their respective bank shares, when there was a collapse in the countries' real estate values. Even though a severe correction seems unlikely in Canada, any correction at all-- even minor-- would most likely put downward pressure on the big 5 bank share prices.

The government of Canada recognizes the potential issues as hand, and is taking steps to mitigate. It is unknown at this time if the government intervention will be enough, without causing a slowdown in itself. Some additional macro views to consider, would be that the European debt crisis is not solved, and is back to haunt. With this in mind, any banking issues over in the eurozone at all can cause contagion even with the strong Canadian banks. This is a fact, as demonstrated by what occurred in the most recent financial crisis, and the lows that the Canadian banks hit. This will be apparent by viewing the charts below at circa 2008 / 2009. In addition, note the weakness shown recently, due to the fact that Europe has taken center stage again. Even with the recent positive big 5 earnings, the general sentiment should be that the positive earnings news won't hold, should issues in Europe rear an ugly head and persist.

Some will argue that the Canadian banks do not have much Greek debt exposure on their books. However, this is not the case for all the eurozone countries. Moreover, the fact that the U.S. banks still have exposure, directly (or via CDS), in a sense could pull down the Canadian banks via their related linked weakness. Since the U.S. is Canada's largest trading partner with roughly 77% of total exports, any weakness in the U.S. will have a direct impact on the financial well being of the Canadian economy and its banks. In addition, it doesn't help that Canadians are now at record personal debt levels. Personal debt by Canadians is mostly held by the big 5 banks, and presents additional risk.

In my opinion, it cannot be disputed that if/or when Greece defaults or exits the eurozone, the spooking and actual effects of this event will absolutely affect the big 5 banks in some form, and as a direct result cause a drop in share price. Conservative investors should not have a false sense of security in holding long positions in the big 5. My suggestion would be to setup a stop loss, or hedge in some form or another. Furthermore, for growth investors, additional capital appreciation is highly speculative at this point. This is mainly due to the current uncertainty at play. It would be prudent to wait this out to see if the big 5 can be acquired cheaper, and therefore achieve capital growth by purchasing after any fallout.

RY 5 Year Chart with 50/200 WMA

RY Fundamentals: P/B 2.0, P/E 11.4, ROE 18.7

TD 5 Year Chart with 50/200 WMA

TD Fundamentals: P/B 1.7, P/E 11.8, ROE 15.1

BNS 5 Year Chart with 50/200 WMA

BNS Fundamentals: P/B 1.9, P/E 11.7, ROE 17.4

BMO 5 Year Chart with 50/200 WMA

BMO Fundamentals: P/B 1.4, P/E 10.1, ROE 15.3

CM 5 Year Chart with 50/200 WMA

CM Fundamentals: P/B 2.1, P/E 10.3, ROE 21.4

Note that although dividend growth has existed with the banks, it has not been perfect nor consistent. An observation could also be made, that even after relatively recent positive earnings, there has still been downward pressure on share price. After this round of positive earnings wears off, the negativity of the previously mentioned variables could put further downward pressure on the share prices.

The main point to leave with is that even though the Canadian banks have historically been a good investment, they are not immune to sell offs. A conservative investor needs to use caution, as they do not want to experience severe capital loss, and the risk of a history repeating itself. If held long, the big 5, should be no more than 5% of a total investor portfolio.

Furthermore, for the growth investor, I really can't find any evidence that points towards major capital appreciation for these banks in the short-term. The type of investor that may want to stick around is the long-term dividend cash, or "DRIP" investor that doesn't care for short term fluctuations, because they want to hold the Canadian banks for the next 25 years and DRIP away. Still, even with this strategy, remember the no more than 5% portfolio weight suggestion.

Charts Courtesy of RBC Direct Investing

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.