Should You Short These 3 Banking Stocks?

Banks like Royal Bank of Canada (TSX:RY)(NYSE:RY) seem fairly valued, but investors need to account for a shifting economic cycle that could affect the industry.

| More on:
Double exposure of a businessman and stairs - Business Success Concept

Image source: Getty Images

You’re reading a free article with opinions that may differ from The Motley Fool’s premium investing services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn more

Steve Eisman, the portfolio manager who shot to fame when he bet against collateralized debt obligations (CDOs) during the collapse of the U.S. housing bubble in 2007-2008, has been targeting Canada’s seemingly robust banking sector for his next big short. His concern seems to be that Canada’s debt cycle hasn’t normalized in over 20 years, and some of the country’s largest banks appear ill-prepared.

His firm is now betting against the likes of Royal Bank (TSX:RY)(NYSE:RY), Laurentian Bank (TSX:LB), and Canadian Imperial Bank (TSX:CM)(NYSE:CM).

Eisman isn’t alone. Institutional investors have been pouring billions into their bet against the Canadian banking sector. According to data published by the Financial Times, short bets against the banks are up 19% this year and are collectively now worth $12.3 billion.

It seems institutions are convinced of the banking sector’s weakness, but should retail investors follow them on ditching some of Canada’s most lucrative dividend stocks? Here’s a closer look at the underlying fundamentals for each of the banks Eisman picked.

Royal Bank

RBC is by far one of the largest private lenders in the country. The stock currently offers a 4% dividend yield and trades at a price-to-book ratio of 1.95. At first glance, the bank seems fairly valued.

Laurentian Bank

Comparatively smaller than the other two banks on this list, Laurentian offers investors a better valuation and better dividend yield. At the current market price, the stock trades at 83% of net book value and offers a 6.2% dividend yield — both substantially better than the industry average.

Canadian Imperial Bank

Comparatively larger and more well known, CIBC is mostly in line with the other banks on this list. The dividend yield is 5.5%, while the stock trades at a 34% premium to net book value.

The short thesis

Despite the seemingly attractive metrics, institutional investors are concerned that Canadian citizens and corporations have taken on too much debt, and the delinquency rate is likely to go much higher in the near future as interest rates rise.

Meanwhile, the banking sector has kept either low reserves or negative reserves for such an uptick in delinquency rates. This means banks will have to pay out of pocket if (when?) the credit cycle returns to normal, eroding the profitability and growth of the major banks.

Early indicators seem to be validating these concerns. Last week, Equifax Canada revealed that non-mortgage delinquency rates were steadily rising in 2019, and the rate at which seniors were defaulting on their debt was up 9.4% year on year.

Although it is too early to say if this trend will continue, the market seems unconvinced. All three of the stocks mentioned in this list are up so far this year. That’s despite other concerns for the Canadian economy such as a potential recession and the ongoing trade war.

Bottom line

Despite the mounting risks and early red flags about Canada’s economy and debt cycle, the banks seem to be priced as if business conditions will remain stable forever. For investors who understand the cyclical nature of the economy, these banks are best avoided. However, I wouldn’t go as far as saying the average investor should short the stocks and bet against them.  

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium service or advisor. We’re Motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer, so we sometimes publish articles that may not be in line with recommendations, rankings or other content.

The Motley Fool is short shares of Equifax. Fool contributor Vishesh Raisinghani has no position in any of the stocks mentioned.

More on Bank Stocks

Man holding magnifying glass over a document
Bank Stocks

TD Bank Stock Looks Severely Undervalued Going Into the 2nd Half of 2022

TD Bank (TSX:TD)(NYSE:TD) stock has been under pressure amid the TSX Index correction but may be among the best bounce-back…

Read more »

Coworkers standing near a wall
Bank Stocks

Policy Rate: 2 More Hikes After July 2022 to Reach Neutral Level

The Bank of Canada might need three more rate hikes beginning in July 2022 to reach neutral levels.

Read more »

You Should Know This
Bank Stocks

75-Basis-Point Rate Hike? Here’s What it Means for Stocks

Aggressive rate increases dampen investors’ sentiment and send share prices tumbling, because the hikes can impact corporate earnings or profits.

Read more »

You Should Know This
Bank Stocks

TD Bank Stock Faces Challenge From U.S. Senate!

Toronto-Dominion Bank's (TSX:TD)(NYSE:TD) latest deal is being blocked by the U.S. Senate.

Read more »

question marks written reminders tickets
Bank Stocks

Is TD Bank (TSX:TD) or Royal Bank (TSX:RY) Stock a Buy?

Canadian banks appear oversold. Is this the right time to buy TD or Royal Bank stock?

Read more »

edit Close-up Of A Piggybank With Eyeglasses And Calculator On Desk
Bank Stocks

2 Top TSX Financial Stocks to Buy for a Retirement Fund During the Market Correction

These top TSX financial stocks now look oversold for a self-directed TFSA or RRSP portfolio.

Read more »

Growth from coins
Dividend Stocks

Dividends Aren’t Guaranteed, Yet 3 TSX Stocks Keep Raising Payouts

No company will guarantee dividend payments, but three TSX Dividend Aristocrats will not break their dividend-growth streaks.

Read more »

Bank Stocks

Should You Buy TD Bank (TSX:TD) Stock Now?

TD stock looks oversold. Is this the right time to buy?

Read more »