Are Canadian Bank Stocks Now Oversold?

The share prices of the large Canadian banks are down considerably this year and now trade at levels not seen since late 2020. Contrarian investors seeking quality dividends and a shot at big capital gains are wondering which TSX bank stocks are now undervalued and good to buy for a Tax-Free Savings Account (TFSA) or Registered Retirement Savings Plan (RRSP) portfolio.

Why bank stocks are falling

The Bank of Canada has aggressively increased interest rates to try to get inflation under control by cooling off the hot economy and loosening up the tight jobs market.

Rate hikes are normally positive for banks as lenders can often generate better net interest margins as interest rates rise. The speed and extent of the rate hikes over the past 18 months, however, are driving fears that businesses and homeowners with too much debt are going to have to default on their loans and mortgages.

The cracks are already starting to show. Banks increased their provisions for credit losses (PCL) in the fiscal third quarter (Q3) 2023 compared to last year. This is money they set aside to cover potential bad loans and has a paper impact on reported profits. If things don’t go as bad as expected, as occurred during the pandemic when government assistance kept many businesses and homeowners solvent, the PCL can be reversed and shows up as a boost to income.

Investors appear to be of the opinion that some serious pain is on the way. This, for the moment, is more negative than the general view of economists who broadly expect the Bank of Canada to navigate a soft landing for the economy as inflation falls back to 2% and interest rates begin to decline.

There is a risk, however, that the central bank has gone too far and will keep rates elevated for too long to make sure inflation doesn’t get sticky. It is a fine line to walk. Experts say the full impact of a rate increase takes 12-18 months to work its way through the economy.

If consumers stop spending and job losses surge at the same time that interest rates remain high, a sharp economic downturn could materialize. In that scenario, the banks would likely be in for a rough ride.

At their current share prices, this seems to be the outcome the market anticipates. Where things end up is anyone’s guess.

Which banks stocks are oversold?

Royal Bank (TSX:RY) is Canada’s largest bank by market capitalization with a current valuation near $153 billion. The stock is down 15% in 2023 and trades close to $108 at the time of writing compared to $147 in early 2022.

Royal Bank is trying to get its $13.5 billion acquisition of HSBC Canada across the finish line. If that occurs in the first part of next year, the bank should see a nice boost to revenue and earnings. At the current share price, RY stock provides a 5% dividend yield.

TD (TSX:TD) abandoned its planned US$13.4 billion takeover of First Horizon, an American regional bank, earlier this year due to regulatory hurdles. The decision forced TD to lower its earnings guidance for the year. TD now intends to grow its American operations organically and has a very large capital cushion to ride out economic turbulence. TD stock is down 13% in 2023 and now offers a yield of 5%.

Bank of Montreal (TSX:BMO) successfully closed its US$16.3 purchase of Bank of the West in early 2023, shortly before a handful of regional banks went bust in the United States and sent share prices tumbling. Investors might be concerned that Bank of Montreal paid too much to buy Bank of the West. BMO stock is down 17% in 2023 and now provides a 5.7% dividend yield.

Bank of Nova Scotia (TSX:BNS) has a new chief executive officer this year who is evaluating the strategic value of the various parts of the business, including the large international operations that are primarily located in Latin America. The bank just announced job cuts that will trim the workforce by about 3%. BNS stock is down 15% in 2023 and currently offers a 7.6% dividend yield.

CIBC (TSX:CM) is the smallest of the five largest Canadian Banks but arguably has the biggest relative exposure to the Canadian residential housing market. The stock is down 13.5% in 2023 and now offers a dividend yield of 7.2%.

Is one a better buy?

At this point, all the large Canadian banks are likely undervalued. Royal Bank is probably the safest pick, while Bank of Nova Scotia and CIBC look good for a portfolio focused on passive income. Ongoing volatility should be expected, but contrarian investors might want to start nibbling on their favourites at these levels.