The share prices of Canada’s biggest banks have surged over the past year as global investors look to diversify and park their money outside of the United States amid economic uncertainty, a falling U.S. dollar and high valuations, but some analysts are questioning whether that trend can help continue the rally.

“While we remain constructive on the large banks’ medium-term outlook, we believe the set-up heading into (second-quarter) earnings season is a bit challenging,” Mike Rizvanovic, an analyst at Bank of Nova Scotia, said in a note on Thursday.

That’s because various metrics suggest that the Canadian banks could potentially be overvalued.

For example, the Big Six’s price-to-earnings (PE) ratio, a key metric that compares a company’s share price to its profit, has surpassed historical highs.

The PE ratio was about 13.7 on May 5, Rizvanovic said, meaning investors were willing to pay $13.70 for every $1 of earnings the banks are expected to generate, comfortably above the historical average of 11.2.

In other words, investors are pricing in fairly high profit expectations, so the bank’s earnings being released next week may not give stocks much of a lift unless clearly beat analysts’ forecasts.

The banks’ price-to-book value — what a company would be worth if it sold its assets and paid off its liabilities — is also trading above historical highs: 2.2 compared to the 10-year historical average of 1.6, according to Paul Holden, an analyst at Canadian Imperial Bank of Commerce.

“We expect a strong set of earnings, predominantly based on capital markets activity,” he said in a note on Wednesday. “The credit outlook is incrementally worse and, given where valuation multiples sit, we question whether the stocks will trade higher on capital markets-driven beats.”

Holden also said the banks’ dividend yields are less attractive than in the past, with an average yield of three per cent compared to the 10-year average of 4.4 per cent.

But the Big Six have consistently beaten expectations in the past two years, so it may be unwise to bet against them, Gabriel Dechaine, an analyst at National Bank of Canada , said.

“Barring a margin or credit surprise, the onus falls on the capital markets to deliver this outcome, which isn’t impossible considering several favourable market conditions,” he said in a note on Thursday.

One of those favourable market conditions include global investors looking for ways to diversify away from U.S. dollar assets and AI-heavy U.S. stock market dynamics amidst economic uncertainty, Mehmet Beceren, a senior markets strategist at Rosenberg Research & Associates Inc., said.

That search has led to investors towards metals, oil, gold and markets that offer a more tangible link to resources, which Canada has plenty of, he said.

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“Last year’s gold price and overall commodity rally has become a tailwind for the Canadian assets that tend to benefit from these kind of rallies,” he said, “Money flowed into the Canadian markets, which then inevitably flowed into the Canadian banks, which are the largest companies in the index.”

As a result, Beceren said everything has been revalued since the banks and other sectors began benefiting from the new market conditions.

That’s reflected in how well bank stocks have traded in the past year, with Canada’s biggest banks up more than 50 per cent.

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But Beceren said investors shouldn’t compare bank stocks to their historical norms because everything adjusts on a relative basis. A different way is to compare them with foreign lenders.

Canadian bank stocks look expensive against U.S. and European banks, but their valuations are cheaper compared with banks in Australia, another commodity-driven economy.

This provides hope for the Big Six, but Beceren said there are also other factors such as housing stress and the rise in unemployment that could test the banking sector’s quality premium.

• Email: nkarim@postmedia.com