Big 6 Canadian bank stocks downgraded

Moody’s has downgraded the big six Canadian banks. But, much like when a tree falls in the forest, did anyone hear it? Professional money managers, who talk like bulls and sell like bears, are not about to tell you what they’re doing. Behavioural finance analyst Ken Norquay helps you shape your own investment strategy: Buy, sell or hold the big six Canadian banks?

Canadian_bank_stocksPart of the 2008-10 banking crisis was the negligence of the banks’ credit watchdogs. Those who were supposed to warn us of trouble didn’t see the trouble coming. When credit trouble finally arrived, it seemed to come from nowhere, because the watchdogs had fallen asleep. Companies like Moody’s and Standard and Poor’s had not warned their subscribers of the risk in the credit system, and were severely criticized for this failure.

Moody’s lowered its ratings of the big six Canadian banks this May, citing a high-risk, real estate market and excessive consumer debt as potential problems. Moody’s is not a sleeping watchdog this time around.

But if the investment business were that simple we’d all be rich. We’d all pay attention to what the credit experts say and we’d all act on their advice. Unfortunately for ordinary investors, that’s not how the market works.

 In my stock market book, Beyond the Bull, I observe that the investment world is full of conflicting opinions, and heavily biased toward ‘good news’. There is a heavy financial-industry bias towards spreading news that supports a continuing rise in stock prices. The problem is further complicated by the fact that most investment information is presented by salesmen who try to persuade us to follow a particular course of action. Persuasive information is biased information.

The reason most investors don’t act on some watchdog’s advice is that they don’t really believe the advice. The investment strategy followed by most ordinary investors is: “I believe what my advisor tells me, and not necessarily what some other advisor says.” (Most investors don’t express that strategy as frankly as I do.) It’s an ego-based investment plan coming from an investor’s confidence that s/he has found a trusted investment ally and is committed to following that trusted ally’s advice.

I recommend a different investment strategy—a more conservative, objective strategy.

Formulate the right investment strategy

First of all, we should only own investments that are trending up. The price is rising over time. That means we need a way of measuring the price trend.

Secondly, we need an entry strategy: When should we buy?

Thirdly, we need an exit strategy: When should we sell?

Fourthly, we need some reliable sources of data. We observe accurate financial data, and when we see our reasons to buy or sell, we act on those reasons.

Fifthly, we need to have the correct attitude. Who’s in charge? If I get sick or go on vacation, who will be in charge? Can I explain my investment strategy to someone and have confidence that they could take charge of my investments for a while? Or am I flying by the seat of my pants, wishing and hoping rather than watching and acting? When I make a mistake, how do my emotions hold up? When I get very lucky, how does my humility hold up?

The banks’ downgrade

With this attitude in mind, let us review Moody’s downgrade. Is it an important piece of data in our long-term investment strategy, or is it merely one more bit of financial news in a barrage of irrelevant news stories?

To make this value assessment, we’ll first review the trend of the major financial markets.

The U.S. stock market touched a new high this month, confirming its long-term uptrend. The Canadian stock market is lagging behind. In February of this year it finally exceeded its Sept 2011 high by a mere 2 per cent: long-term neutral, short-term up.

U.S. and Canadian long-term interest rates, as measured by 20-year + bond yields, touched a low in July of last year. Since then, the trend has been gently up.

Strategic note: our counter-cyclical model notes that long-term interest rates normally bottom approximately 6 months before the stock market tops. The low in interest rates occurred 10 months ago, in July 2016. Normally, the stock market would have reversed from up to down by now. The exceptional post-financial-crisis monetary stimulus of the past few years has caused the stock market uptrend to extend longer than usual.

The long-term trend of gold bottomed in December 2015: Gold and silver prices are currently in a weak up trend.

The long-term trend of oil prices reversed from down to up in February 2016. The current trend is up, albeit a weak uptrend.

Strategic note: Oil stocks and precious metals stocks respond to oil and gold prices. Speculators can look for trading opportunities in these sectors. Because the U.S. stock market is so close to a top at this time, traders should be extra vigilant. Oil and gold stocks will also respond to a downtrend in the stock market.

The U.S. dollar, measured against the basket of non-U.S. currencies, has been in an uptrend since the financial crisis low in 2008. That uptrend has been quite weak since March 2015.

The Canadian dollar, as measured against the U.S. dollar, is celebrating the 6th year of a downtrend that began in May 2011.

Strategic note: Canadian stock market investors should continue to hold a higher-than-usual percentage of their portfolios in U.S. stocks. This will take advantage of these continuing currency trends.

Is the downgrade warranted?

The Canadian bank stocks have, on average, been in uptrends since the March 2009 stock market low. Their highest prices during that time were reached about 3 months ago. Here is a list of Canada’s six big banks, ranked by their percentage gain in the eight years, from the 2009 low to their February 2017 highs:

National Bank, 487 per cent gain;
TD Canada Trust, 441 per cent gain;
Bank of Montreal, 433 per cent gain;
Royal Bank, 391 per cent gain;
Bank of Nova Scotia, 343 per cent gain;
Canadian Imperial Bank of Commerce, 331 per cent gain.

Since that same 2009 low, the S&P500 index went up 360 per cent, and the TSX index 213 per cent.

The Theory of Contrary Opinion tells us that risk is directly proportional to price. In March 2009, the risk in bank stocks was at its lowest point in the past 8 years. Earlier this year, risk was at its highest point. But in 2009, when risk was low, there was a bank crisis and everyone perceived that risk was high. (That’s why it’s called The Theory of Contrary Opinion.) When Moody’s recently lowered its credit rating of the Canadian banks, several analysts minimized Moody’s assessment and downplayed the risk. It appears that ‘everyone’ now thinks that bank-stock risk is low. The watchdog is barking, but ‘everyone’ is ignoring it.

Is that statement really true? Is ‘everyone’ really ignoring Moody’s warning? Imagine yourself as the manager of a $10 billion investment portfolio. You read the Moody’s report and decide to reduce your percentage holdings of bank stocks from 32 per cent to 22 per cent.

Question: How will you implement your decision?

Answer: Sl-o-o-o-o-w-ly.

In order to sell $1 billion worth of bank stocks at current prices, you need to have investors who are willing to buy $1 billion of bank stocks at current prices. If you appear on BNN or in The Globe and Mail, and you are asked: “What do you think of the bank stocks in light of Moody’s downgrade?”—what will you say?

Stealth Selling

In your heart of hearts, you believe in Moody’s and have decided to sell some of your holdings. But if you make this view public, your potential bank stock buyers will back off. Your public bearishness will cause those potential buyers to delay their buying programs, waiting for a lower price. Your expression of bearishness hurts your portfolio’s performance because it discourages potential bank stock buyers from buying now.

In my stock market book Beyond the Bull, I call this “stealth selling”. Money managers talk like bulls and sell like bears. This type of deception is an integral part of the financial markets: It is the duty of your portfolio manager to operate in this way. It’s how s/he gets you the best prices when s/he sells.

(There is another storm cloud on the horizon for the Canadian banking industry. The government is currently reviewing an illegal activity called ‘cross-selling’, where bank employees are told to sell other bank products to their customers. For example, a mortgage customer might be offered home insurance. We all know cross selling happens: It will be no surprise to the customers when the government finally figures it out.)

This is an edited version of an article that was originally published for subscribers in the May 2017/Second Report of The MoneyLetter. You can profit from the award-winning advice subscribers receive regularly in The MoneyLetter.

The MoneyLetter, MPL Communications Inc.
133 Richmond St. W., Toronto, On, M5H 3M8, 1-800-804-8846