Quarterly Letter

April 2023 – Quarterly Letter

By May 5, 2023 No Comments

May 11, 2023

Investors have experienced a challenging few months despite the low level of market volatility. The collapse of Silicon Valley Bank has had a domino effect on smaller, non-systemically important financial institutions (SIFI). We haven’t seen a substantial bank fail since the global financial crisis of 2008-10. The root cause of the recent bank failures is very different from 2008-10.

Back then, the bank industry’s exposure to real estate foreclosures and the collapse in housing prices threw the banks into default. Today, the increase in interest rates is causing savers to shift their savings from savings accounts to money market funds. In the case of Silicon Valley Bank and First Republic, they had invested savers’ assets in long-term treasury bonds as long-term bonds pay a higher interest rate than short-term T-bills.

The credit quality of the treasury bonds is not in question. The problem is that the banks in question did not keep enough cash on hand to meet withdrawals. When withdrawals from savers forced the banks to liquidate part of their investment portfolio, they were forced to sell long-term treasury bonds at a loss.

Silicon Valley Bank and First Republic share some common characteristics. Both banks catered to high-net-worth individuals. Many of their customers were tech entrepreneurs and recipients of private equity and venture capital. These customers are highly connected and tend to move as a herd. Once word spread that the banks were taking losses on their investment portfolios, the run on the banks picked up speed.

Silicon Valley Bank incentivized founders to keep most of their wealth in the Silicon Valley Bank by offering them higher interest rates. 97% of the savers’ deposits were more than the $250,000 limit of what the FDIC will insure. Once customers recognized that their savings were at risk, depositors raced to liquidate their accounts, pulling out $42 billion on one Friday. Over the following weekend, the FDIC seized the bank, and the collapse was complete. Over the following weeks, banks that had also aggressively “borrowed short and lent long” began to topple. UBS was handed over to the stronger Credit Suisse bank, and the FDIC took over First Republic and then sold it to JP Morgan.

At this point, it appears that the banking crisis is going to play out more like Long-Term Capital Management than Bear Stearns. In 1998, Long-Term Capital spooked the markets and knocked them down about 10% before the Federal Reserve engineered a rescue. The rescue of the wobbling hedge fund led to a 73% rally in the S&P 500 over the next two years.  The Bear Sterns rescue turned out to be a canary in the coal mine. In 2008, it became increasingly obvious that the assets on the balance sheet of almost the entire banking industry were mispriced. That led to a sudden, industry-wide collapse from which the economy took years to recover.

One potential silver lining to the current bank crisis is that the Federal Reserve is now much more reluctant to raise interest rates any further. The banking crisis will slow the rate of credit creation. This will cause the economy to grow at a slower rate.

The Federal Reserve’s primary mission for the last eighteen months has been to slow down the rate of economic growth to reduce the rate of inflation.  At the last meeting, it effectively declared victory by suggesting that the current cycle of interest rate increases is now over. I don’t think we’ll see inflation below 2% anytime soon, but it should get back down to the average of the last 75 years of around 3.5%.

The economy is clearly slowing. The question remains whether the economy will tip over into recession, or whether economic growth will rebound going into 2024. The immediate outlook is for an accelerating growth rate. The Federal Reserve’s GDPNow forecast projects a second quarter growth rate of almost 3%, much higher than the projection of private sector economists.

If you just listened to economists and the forecasters of the large investment banks, you’d assume that we are already in a recession, or that a recession is inevitable. The current level of pessimism is unusual, and not limited to economists. Of the twenty most widely recognized investment strategists on Wall Street, the average year-end price target for the S&P 500 is about 4,050—a couple percent lower than today’s price. Analysts are not very hopeful about earnings, either. Earnings estimates have come down this year, although they seem to be stabilizing over the last three months.

You can’t blame investors for assuming the market can’t go up if earnings expectations are falling. Intuitively, it makes complete sense. Yet, it’s not that simple. 80% of market bottoms occur prior to the low in earnings expectations. Even though the market is substantially higher over the last seven months, investors are still extremely pessimistic. Amongst individual retail investors since 1987 there are only two periods with higher levels of investor pessimism–2009, and 1991, both coincided with the beginning of multi-year bull markets.

So, what do we know for sure?

1.       Investors are extremely pessimistic. This has historically coincided with market bottoms, not tops.

2.       Inflation has peaked and is falling substantially.

3.       The Federal Reserve is signaling that they are done raising interest rates.

4.       Typically, markets bottom prior to earnings and economic growth.

5.       The market is up by more than 5% each of the last two quarters.

The last point may be the most important. Since 1950, when the S&P 500 posted back-to-back quarterly gains of at least 5%, the stock market was higher the next year 87% of the time with an average gain of 13.5%.

It’s been a grinding 18 months or so. Even though the market is higher over the last seven months, it’s basically in the same place it was a year ago. In that timeframe, the market has overcome a number of challenges. Even if the economy goes into recession, given what we’ve overcome, chances are that the market will be higher at the end of this year.

Eric Barden, CFA