Don’t be so dismissive of The Big Short’s bet against the Canadian banks

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U.S. hedge fund manager Steve Eisman became famous through his depiction in Michael Lewis’s financial crisis book, The Big Short, which detailed the manager’s successful shorting of markets before the crisis hit. Mr. Eisman is now infamous in Canadian investing circles after reports, initially in the Financial Times, said he has built short positions against Canadian bank stocks.

Bank of Montreal is a potential target for one of the short positions (Mr. Eisman would not comment on specific stocks) so it might be surprising that BMO economist Robert Kavcic recognizes the validity of the trade, writing, “it actually isn’t that over the top, calling for slower economic growth and normalizing credit conditions. We’d actually agree on both counts.”

It’s not the potential success or failure of the bet against banks I want to discuss anyway, it’s the dismissive reaction I’ve been seeing on social media such as Twitter from Canadian investors – “Good luck with that, Loser” is not a huge exaggeration – that interests me most.

I have a relatively vivid imagination but can’t foresee any situation where any of the major Canadian banks, with the Bank of Canada standing behind them with the ability to print money, will experience anything close to insolvency. That said, one of the primary lessons of the financial crisis is that, at the end of an unprecedented credit cycle, no company is immune.

It’s true that Canadian banks have been consistently great investments over the past, well, forever, but it’s also true that Canadian households have never carried debt loads amounting to almost 180 per cent of disposable income.

In Mr. Eisman’s case, Canadian investors should not so easily dismiss a manager with undeniable credibility in predicting the end of financial cycles.

My original assumption on the news of Mr. Eisman’s pessimistic bets on domestic banks was that the short positions were part of a pair trade, likely U.S. bank stocks. This would have involved the manager taking the proceeds from shorting the banks and buying U.S. banks for a similar amount of assets. Had this been the case, the trade would have been profitable as long as U.S. bank stocks outperformed their Canadian counterparts.

Mr. Eisman was generous enough to disclose to me by e-mail that his positions on Canadian banks are not one half of a pair trade, but what are called naked shorts – trades that will stand or fall based on the single stock price involved. This makes them expensive for his fund to maintain – when short positions are covered, the dollar amount to be paid back includes any dividends that were paid.

I didn’t pull the “short domestic banks to buy U.S. banks” trade guess out of thin air. In 2015, Merrill Lynch strategist Michael Hartnett proposed this strategy as one of his most promising trades of the year, and I’ve been following its progress ever since.

The accompanying chart shows the profitability of Mr. Hartnett’s older trade idea since the beginning of 2015 using relevant exchange-traded funds. In Canadian dollar terms, U.S. banks have consistently outperformed domestic banks for the period, by 22 per cent cumulatively.

Market history gives Canadian investors every right to be confident about the long-term future of domestic bank stocks. On the other hand, the derision and blind faith apparent in the reaction on social media to news of Mr. Eisman’s short positions are unhealthy. Doubting Canadian bank stocks does not automatically make someone of Mr. Eisman’s history an idiot, and as Mr. Hartnett’s trade idea highlights, shorting Canadian banks has already been very profitable for some.

Scott Barlow, Globe Investor’s in-house market strategist, writes exclusively for our subscribers at Inside the Market.