End of Q1 Impacts March Trading Julius Caesar failed to heed the famous warning to “beware the Ides of March” but investors have been served well when they have. Stock prices have had a propensity to decline, sometimes rather precipitously, during the latter days of the month. Over the recent 21-year period, March has tended to open well with gains accumulating over its first three trading days. A brief bout of weakness follows before all indexes begin moving modestly higher into mid-month through month’s end. March packs a rather busy docket. It is the end of the first quarter, which brings with it Triple Witching and an abundance of portfolio maneuvers from The Street. March Triple-Witching Weeks have been quite bullish in recent years. But the week after is the exact opposite, In March 2020, DJIA plunged nearly 4012 points (-17.3%) during the week ending on the 20th. Solid late-March gains in 2009 and again in 2020 have improved average second half of March performance, but most bullish days are still in the first half of the month.
Why Invest in Stocks When Bond Yields are High? Posted on March 3, 2023 TINA, or “There is No Alternative,” was the theme of the last decade as interest rates were close to zero. Yields on long-term bonds weren’t much above that. So, stocks were the “only alternative” if someone wanted reasonable returns. But now it looks like there is an alternative, thanks to the Federal Reserve’s aggressive rate hikes. CREAM, or “Cash Rules Everything Around Me,” looks attractive enough to replace TINA. Three-month treasury bills, which could be considered the best proxy for a liquid and “risk-free” asset, currently yield about 4.9%, while 10-year treasury notes yield around 4%. These yields are salivating, more so because we haven’t seen anything like it in 15 years. Consider stocks on the other hand. And instead of dividend yields, let’s look at earnings yields. Earnings yields that are corrected for cyclical effects are a good predictor of long-run real returns for stocks (I’ll come back to the “real” part shortly). For example, if a company paid out all earnings as dividends, then the earnings yield would equal the dividend yield. Earnings yield is basically the inverse of the Price to Earnings ratio. There are myriad approaches to estimating earnings, but let’s keep it simple. For example, if a stock trades at $100 and its expected earnings per share over the next 12 months is $5, it has a forward P/E ratio of 20. And an earnings yield of 5/100 = 5%. Meaning every dollar invested in the stock would “yield” 5 cents. At the end of 2019, the S&P 500 was trading with a forward P/E of 18.5, i.e., with an earnings yield of 5.4%. Which was pretty good when you consider that 10-year treasuries were yielding about 1.7%. It implied an “equity risk premium” of about 3.4%— which is the excess return investors require to hold risky assets like stocks. Right now, the S&P 500 is trading at a forward P/E of 17.5, which translates to an earnings yield of 5.7% and a tad better than the pre-pandemic yield. The problem is that with 10-year treasury yields around 4%, the implied equity risk premium (ERP) has seen a sharp compression, as shown in the chart below. Which gets to the title of this piece: why should I invest in stocks when risk-free yields are as high as they are? Not a great timing tool For one thing, the ERP, as calculated above, is not a great indicator of future returns, let alone a timing tool that tells you when to hold stocks and when to shift to bonds. The last time the premium was as low as today was in June 2007, when it was 1.6%. Over the next ten years, bonds had an average annualized return of 4.5% versus 7.2% for the S&P 500— and that came despite a 50%+ pullback in 2008-2009! Over the next 15 years, bonds had an average annualized return of 3.3%, versus 8.5% for the S&P 500—and you had two massive pullbacks, in 2008-2009 and 2020. In any case, this approach to calculating the ERP has its faults. Stocks are real assets One problem with the above approach for calculating the ERP is that stocks are real assets whose prices rise with inflation. Also, corporate earnings move higher with inflation since companies are able to pass along rising input costs over time to their customers. As Jeremy Schwartz at WisdomTree points out, this pricing power is evidenced by the fact that long-term earnings and dividend growth had outpaced inflation (even during the 1970s and 1980s when inflation was high). Cliff Asness at AQR makes the same case here, arguing that the appropriate comparison is earnings yield to real risk-free yields, as opposed to nominal yields. The picture looks a little better when you do that, though the ERP determined that using this approach is still lower than what it was pre-pandemic. That is because real risk-free yields, as measured by inflation-indexed treasury bonds, have climbed sharply since then. The 10-year real yield was close to zero at the end of 2019 and fell as low as -1.2% in August 2021. The Fed’s aggressive rate hikes resulted in a dramatic upward shift in 2022, with the 10-year real yield currently around 1.6%. The chart below shows ERP estimated using real yields. It’s fallen to 4.2%, but that’s still some serious premium. Which is why we continue to overweight stocks over bonds for our long-term Carson House View allocations. An even better alternative So far, we’ve been looking at earnings yields and risk premiums for the broad stock market, as measured by the S&P 500. And as we saw, it may not be the greatest timing tool with respect to stocks vs. bonds. But it can help point you toward more attractive parts of the stock market. Look one step below the broad stock market index, and there are some large variations. Especially if you separate value stocks from growth stocks. Value stocks typically tend to have lower P/E ratios (and higher earnings yields) than growth stocks, which typically have high P/E ratios (and lower earnings yields). When real yields were zero or negative, the relatively low earnings yield on growth stocks didn’t matter. Investors could bank on potentially high long-term earnings growth in the future. But the premium over real yields has shrunk dramatically over the past year as real rates rose. It’s currently at 2.9%, close to its 20-year low of 2.7%. Contrast that to the risk premium for value stocks, which is currently at a relatively attractive level of 5.4%. The chart below shows the difference between earnings yields of Value and Growth stocks. It’s currently at 2.6%, which is well above the 20-year average of 1.8%. This is a big reason we are currently overweight value stocks in our Carson House View allocations. Footnote: S&P 500 and bond returns are calculated via Factset using the S&P 500 Index and the Bloomberg US Aggregate Bond Index, respectively.
Nothing Beats Long-run Equity Returns Posted on March 6, 2023 8 Principles of Equities: #1 – Nothing Beats Long-run Equity Returns Carson Investment Research recently published our 8 Principles of Equities. The first is the most important—In our opinion, nothing beats long-run equity returns. Not bonds. Not housing. Not gold, oil, or copper. Frankly, it’s not even close. Sure, there may have been periods of exception, but they haven’t lasted long. Yet, it can be easy to lose this perspective, especially during a downturn or heightened volatility and uncertainty. It is during these times that we get a parade of TV and radio ads that act like they have discovered some magical high-return/low-volatility asset, such as real estate, gold, commodities, etc. Certainly, these are useful for meeting retirement goals, especially with portfolio diversification and reducing volatility. However, when it comes to long-term returns, the stock market is arguably the undisputed champ among major asset classes. We all know the famous long-term investing quotes. We won’t rehash them here. Carson’s Chief Market Strategist, Ryan Detrick, already wrote a great article about how the longer investors hold stocks, the greater the odds of positive returns. Here, we want to illustrate the extent of those returns over other major asset classes. The chart above shows that stocks have fared quite well relative to other major asset classes. If we just look at 100-year data (1920-2020), equities have outperformed 10 and 30-year Treasury bonds by more than 4.5% per year, corporate bonds by 3.7%, gold by 5.6%, and oil by 8.4%. What about inflation? As my colleague, Sonu Varghese, recently wrote, stocks are real assets. The historical data bears this out. Stocks expand their lead over other asset classes in “real” terms, or after inflation. From 1920 to 2020, equities posted annualized real returns of 7.7%. Housing (ex-rents) were just 1.1% per year, and the overall commodity index was actually negative 1.1% per year! Only gold (2.0% per year) and copper (0.5% per year) were positive. The closest annual real return to equities over these 100 years is BBB bonds at 4.2% per year. To be sure, there have been periods where equities have lost their crown, at least temporarily. However, they have been rare. Since 1800, there have only been 6 decades out of 22 where they weren’t the top performing asset class, or less than 1/3 of the time. Other than equities, only gold has ever been able to repeat as the champion –during the 1970s after the US abandoned the gold standard and the other in the 2000s during the bursting of the dot-com bubble and the global financial crisis. Unquestionably, stocks are king. However, they are also volatile, so investors should be compensated with higher returns compared to most asset classes. This is why we continue to overweight stocks in our long-term Carson House View allocations. Our next three Principles cover the risk aspect of the stock market, which is the part that usually keeps investors from reaping all of its rewards. We look forward to diving deeper into these soon.
Small Cap Seasonal Strength Ending There has been much ado about the recent outperformance of small caps versus large caps – it has been impressive and welcomed. When small caps do well it’s a good sign. Many are U.S. based and not multinational or international firms like many large caps are. So, when U.S. small caps do well it’s a sign of economic health for the U.S. Small caps as measured by the Russell 2000 have also led the early stages of this nascent bull market. They were the first to bottom in June 2022 and constructively held that low at the October 2022 bottom. But small-cap outperformance since mid-December may have a lot to do with seasonality. As detailed on pages 112 and 114 of the 2023 Stock Trader’s Almanac small cap outperformance, known as the “January Effect,” has historically begun to wane in February as the bulk of the move from around mid-December has already occurred. In the chart here, daily data from July 1, 1979, through March 3. 2023 for the Russell 2000 index of smaller companies are divided by the Russell 1000 index of largest companies, and then compressed into a single year to show an idealized yearly pattern. When the graph is descending, large-cap companies are outperforming small-cap companies; when the graph is rising, smaller companies are moving up faster than their larger brethren. The most prominent period of outperformance generally begins in mid-December and lasts until late-February or early March with a surge in January.
Why the Dollar Matters For International Equity Investors Posted on March 7, 2023 Last year the MSCI EAFE Index, which represents a basket of developed market stocks, fell 14.5%. Meanwhile, the MSCI Emerging Markets (EM) Index lost 20.1%. It turns out the returns for these baskets were higher in local currency terms, and there was a big drag from a stronger dollar. In local currency terms, the MSCI EAFE index lost “only” 6.5%, while the MSCI EM Index lost 15.2%. 2022 was really a tale of two periods when it came to the dollar. Over the first three quarters, the US dollar (USD) appreciated significantly against other currencies. This came on the back of the Federal Reserve surprising investors by taking an aggressive approach to get on top of inflation. This contrasted with other central banks around the world, including in Europe and Japan, who weren’t quite so aggressive – mostly because their economies were weaker than the US, and being overly aggressive ran the risk of tipping things into an immediate recession. As a result, interest rate differentials between the US and other countries grew, and to a first approximation, rising interest rate differentials should boost the currency. The following chart illustrates how the dollar has typically strengthened when interest rate differentials climb. We saw this is 2014 and again in 2022. The strong dollar was a big headwind for international equities over the first 3 quarters of 2022. However, as the Fed started to step back on the size of the rate increases by the end of the year, the dollar started to ease. Which was a tailwind for international equities. Then we saw another switch this year. As the economic data came in hot, especially the January employment data, investor expectations for Fed rate hikes increased. Which sent the dollar higher once again, yet again creating a headwind for international equities. All this is a reminder of the currency hurdle that international equities must overcome to offer better performance relative to US equities. The math for international equities is hard But let’s try to simplify it a bit. Consider two investments: stock A with returns of 20% in year 1 and 20% in year 2. Stock B with returns of 50% in year 1 and -10% in year 2. Both assets have an average return of 20%. But the compounded returns are quite different: Stock A: (1 + 0.20) x (1 + 0.20) – 1 = 44% Stock B: (1 + 0.50) x (1 – 0.10) – 1 = 35% The compounded return for stock B is lower because of the “volatility drag”. This also gets to the reason why you always want to reduce portfolio volatility. The currency impact works similarly. Say an international equity basket appreciates 30% in local currency terms. But the currency depreciates 15% against the USD. The USD return is not 30 – 15 = 15% Instead, the USD return = (1 + 30%) x (1 – 0.15) = 10.5% There are 3 pieces to understand here: The investor made 30% on their actual international equity investment They lost 15% on the currency But, they also lost 15% of the 30% equity gain = 4.5% (the “geometric piece”) Combing the three pieces, we get 30% – 15% – 4.5% = 10.5% All this to say, you need to get two pieces right when investing in international equities One, the direction of the equity basket Two, USD vs. local currency The data bears this out as well. The chart below shows the past 22 years of excess returns for the MSCI EAFE Index against the S&P 500, versus currency returns. You can see that international developed market excess returns are typically negative, i.e., US equities outperform when the USD appreciates. And vice versa. A similar dynamic exists for EM. A stronger dollar leads to US equities outperforming EM equities and vice versa. In fact, the relationship is even stronger than what we saw above with developed markets. Part of the reason is that EM local returns are also disadvantaged by a stronger dollar. Normally, you would expect emerging countries to be advantaged by a weaker currency – which makes their exports cheap in international markets, boosting demand for those goods and stimulating domestic activity. However, it turns out there’s a financial channel that offsets the trade impact. A weaker currency can lead to tighter domestic financial conditions. A lot of EM companies borrow in US dollars (since it’s cheaper to do so), but their revenues tend to be in local currency. So when the dollar appreciates, it increases their debt service costs relative to revenue, thus creating a tougher domestic economic environment. The currency hurdle is one reason why we are underweighting international equities from a long-term strategic perspective. However, our near-term tactical view is neutral on developed market equities. This is because we believe the dollar will see downward pressure as interest rate differentials continue to shrink, and that will provide a tailwind. In my next post, I’ll discuss why we believe interest rate differentials will shrink or at least not expand as they did in 2022. Including relative central bank policies, inflation, and economic growth. Stay tuned.
A Closer Look at Seasonality Posted on March 8, 2023 We talked a lot about how February (especially the second half of February) could be a potential break for stocks, well the good news is that we now see many signs of better times potentially coming soon. Here’s what the average year for the S&P 500 looks like. Looking at the chart below, the blue line shows gains from January through April, and November and December are normal. It is the middle part of the year that stocks tend to struggle. Lately, things look a little different. Looking at only the past 20 years showed that stocks tended to bottom in March. This is likely due to major bear market lows taking place during this month in 2003, 2009, and 2020. We’ve shared before that pre-election years tend to be strong for stocks, lower only twice going back to World War II and up nearly 17% on average, making this historically the strongest year of the 4-year Presidential cycle. Looking at these years it is once again common to see the second half of February weakness and a tradeable low in late February. Building on this, we found that pre-election years of a new President do even better, up close to 20% on average. But wouldn’t you know it, right about now tended to be a consolidation period before late March and April strength. What about years that started off with big gains? When stocks gained more than 5% in January (like 2023) we found that a consolidation period took place now and into April. The good news is that eventual gains of close to 23% on average were how things ended up, suggesting any potential consolidation here could potentially be used as an opportunity. Lastly, I’ve seen other places combine many of the things I’ve just discussed and make one composite combining them all. I did that and we called it the Carson Cycle Composite. This proprietary composite looks at the average year, pre-election years, pre-election years under a new President, the past 20 years, and years that had a 5% January. As you can see, this year started off stronger, but as of early March is right in line with what the average composite looks like. Take note, a gain of 15.6% is what has been the average Carson Cycle Composite. The bottom line is many cycles suggest the potential for some type of a consolidation here and now would be perfectly normal, but the likelihood of strength before the end of the year is quite strong.
March Jobs Report: Inflation Concerns Could Derail A Historically Bullish Day Yesterday’s ADP private payroll report was stronger than anticipated with 242k new jobs being added versus expectations for around 200k. In less unusual times, strong employment data would generally be a positive for the economy and the market, but when the Fed is raising rates in an effort to slow inflation, this is not so great. Tomorrow morning the official government tally is scheduled to be released. Expectations are running around the 225k level of net new job creation. Any level greater is likely to only add further pressure on the Fed. And if the opposite transpires, there is still CPI and PPI next week. Historically, March’s job report release day (February numbers) has a bullish track record over the last 23 year. DJI, S&P 500 and Russell 1000 have the best records, up 69.6% of the time. Small-cap stocks, measured by the Russell 2000 have also held up well. Average gains on the day have been mild ranging between 0.06% for NASDAQ and 0.35% for Russell 2000. In the last four years, all five indexes have declined three times, pressuring the days bullish streak.
Panic! At the Fed? Posted on March 9, 2023 Federal Reserve Chair Jerome Powell’s comments this week during his semi-annual testimony in front of Congress did not inspire much confidence with respect to the path for monetary policy. It seems like Fed officials’ are confused as to what they want to do next. Case in point: last month, Powell said that the “disinflationary process has started.” Since then, we’ve had a run of strong economic data, including January payrolls, retail sales, and inflation. And it looks like that was enough to spook the Fed. The shift was clear in Powell’s statements this week: “Inflationary pressures are running higher than expected at the time of our previous Federal Open Market Committee (FOMC) meeting.” And “The ultimate level of interest rates is likely to be higher than previously anticipated.” At the same time, he also said: “If – and I stress that no decision has been made on this — if the totality of the data were to indicate that faster tightening is warranted, we would be prepared to increase the pace of rate hikes.” Markets were clearly taken aback by his comments, with equities falling 1.5% on Tuesday (March 7th) and rate hike expectations rising. This becomes clear if you look at expectations for their March meeting. Last Friday, markets were expecting a 0.25% increase in the federal funds rate, pricing the probability of that at 72%. That’s shifted significantly since Powell’s comments this week. Investors moved the probability of a 0.25% increase down to 28%, and the probability of a 0.50% increase rose to almost 80%. This is a huge shift, especially this close to a meeting. Typically, the couple of weeks prior to the meeting is a “quiet period,” where Fed officials don’t give speeches or comments, i.e., anything that may lead to a shift in expectations. The last time this happened was in June 2022, when the Wall Street Journal reported that the Fed was considering raising rates by 0.75% instead of the 0.50% they guided markets toward. There’s not much reason to panic To be clear, the January data was hotter than expected. But this is just one month of data and is likely a rebound from the relatively soft December data (which, at the time, led to increased recession calls) and perhaps positive weather-related effects. We’re yet to get February data, but it’s hard to believe the string of hot data continues into February and March. Take vehicle sales, for example. Sales surged 19% in January to a 15.9 million annualized pace, the highest since May 2021. But sales pulled back to 14.9 million in February. So the trend is still positive, but nothing suggests that the economy is overheating to the extent that the Fed has to up-end market expectations for upcoming policy. The Carson Investment Research team has been in the camp that the economy will avoid a recession this year. As we’ve discussed before, we believe consumers are in good shape, and real incomes are rising, which should keep consumption humming along. This gets to the point that we don’t see the Fed cutting rates any time soon. Expectations for the terminal rate, i.e., the highest rate the Fed will get to, also rose this week. At the beginning of the year, investors expected the terminal rate to end up around 4.9%. That’s now increased to about 5.6% on the back of strong economic data. The good news is that, at the end of the day, positive economic data is positive. This perhaps explains why equities have remained resilient this year. The S&P 500 is up just under 4% year-to-date, despite rate expectations repricing higher. That’s a big shift from last year and a positive one. And we believe equities have the potential to remain resilient, even as the economic data (and the Fed) swing back and forth.
Payrolls Strong but Unemployment Rises: All Mixed Up Posted on March 10, 2023 Another month, another solid employment report. Employment rose by 311,000 in February, on the back of 504,000 in January and 239,000 in December. It’s certainly been a warm winter. This is the labor market that refuses to give in, despite the Fed throwing almost 500 bps (5%-points) of rate hikes at it and gearing up for more. But the unemployment rate rose … Yes, the unemployment rate rose to 3.6%, up from 3.4% in January. However, that was entirely for positive reasons. The unemployment rate, as the Bureau of Labor Statistics (BLS) measures it, is the number of people unemployed who are looking for work divided by the size of the labor force. Last month, the number of unemployed people that are looking for work rose by about 240,000. However, that’s because 419,000 people “entered” the labor force, i.e., started looking for work. That’s a sign of a healthy labor market. People will start looking for work only if they think they can get a job. The labor force measure has issues related to how participation is measured – they count someone as being in the labor force only if someone is looking for work. But a lot of people may not do so for any number of reasons, including not feeling confident in the job market or non-economic reasons like not having access to childcare. The measure also can fall over time because of a lot of retiring baby-boomers. One way to get around these issues is to look at the employment-population ratio for prime age workers, i.e., workers aged 25-54 years. This measures the number of people working as a percent of the civilian population – think of it as the opposite of the unemployment rate, and because we use prime age, you get around the demographic issue as well. The good news is that the prime-age employment-population ratio just hit 80.5%, which is close to the highest level we’ve seen in a couple of decades. It helps to recall that we just had a multi-generational black swan event in the form of a pandemic. But once everything re-opened, the expectation was that things would bounce back immediately. And a lot of numbers did, including GDP, employment, and consumption. However, there were also a lot of people who left the labor force amid the pandemic. And what we’re seeing now is that each month there’s a continuous flow of people back into the labor force, and these people are finding jobs quickly. Just over the past six months, 1.5 million more people have come into the labor force as prospects for finding a job improve. Make no mistake, this is a really strong labor market in my opinion. Is the labor market too strong? It’s weird to even ask that question, but it matters for the Federal Reserve. In their model for the economy, they see a tight labor market as one that results in stronger wage growth. And strong wage growth can drive demand higher, pushing up prices and inflation. Well, hopefully, they can rest a little easy on that front. Average hourly earnings rose just 0.2% in February. Over the past three months, wages have been growing at an annualized pace of 3.6%, well below the 6%+ pace we saw last year. It’s getting very close to the pre-pandemic pace of 3.1%. This backs up other evidence that wage growth is indeed easing, including the Employment Cost Index, which is the gold standard of wage growth measures. The ECI was running at an annualized pace of 4.2% in Q4 2022, down from 4.8% in Q3. The January-February hourly earnings data suggest that wage growth continues to decelerate. The big question is whether the Fed buys this. Powell’s comments this week in front of Congress did not inspire confidence. It looks like a string of hot economic data has left them questioning their decision to ease the pace of rate increases from 50 bps to 25 bps (as of February) – and wondering if they should move that back up to 50 bps at their March meeting. At this point, markets think the outcome is a coin toss, which is not great as Powell simply injected maximum uncertainty into markets. But looking beyond the Fed’s March meeting, the big picture is that the labor market appears to remain really strong. This means the economy also remains strong, and that’s not a bad thing as far as markets are concerned. Though it also means the Fed is likely to keep interest rates higher for longer.
What You Need to Know About Silicon Valley Bank Posted on March 13, 2023 “A small spark can start a great fire” – Emmet Fox A bank many of us had never heard of this time last week now has the entire financial spectrum on the brink of disaster. Or does it? Here are some things you need to know about Silicon Valley Bank. The second-largest bank failure ever Things were just fine this time a week ago, but it all came crumbling down in less than 48 hours for Silicon Valley Bank (SVB) and parent company SVB Financial (ticker symbol SIVB). After losing 60% on Thursday, in the end, the 16th largest bank as of the end of 2022 had vanished by the end of the week, with only the failure of Washington Mutual in 2008 larger. This chart from Pranshu Maheshwari puts things in perspective. What happened? Founded in 1983, SVB announced on Wednesday they had sold $21 billion in assets to raise cash and were taking a $1.8 billion loss as a result, while also trying to raise capital as well. Due to dwindling deposits and losses in their holdings, they were forced to sell to shore up their books. As a result, there was a classic run on the bank, as customers demanded their money back and in less than 48 hours, the 16th largest bank with $209 billion in total assets as of the end of 2022 was gone. In fact, it is estimated customers tried to withdraw $42 billion on Thursday alone, about a quarter of their overall deposits. As a result of the flood of withdrawals, they had a negative cash balance of close to $1 billion and couldn’t cover their payments, so the FDIC took over on Friday morning. Why did this happen to SVB? This bank was quite unique in that they focused on technology and healthcare companies, along with venture capital and startups. Heck, their name says it all. They were heavily invested in Silicon Valley and vice versa. In fact, they provided almost half of the financing to US venture-backed technology and healthcare companies. So, whereas traditional banks had various type of customers, SVB was quite lopsided in their type of customers. This worked great when tech and startups soared from 2015 until 2021, but that all changed in 2022. The big issue was technology had been one of the harder hit areas due to the Fed increasing interest rates by historical amounts. So instead of depositing money in the bank, they were taking out more and more to cover the bills. Couple that with the fact SVB had enormous unrealized losses in their portfolios of mortgage bonds and treasury bonds, it was the perfect cocktail for potential disaster. The Fed finally broke something After increasing rates nearly 500 basis points, many think the Fed was simply hiking until something broke. Well, housing broke and now the big worry is the huge drop in bond prices could be breaking things for banks. SVB for example took many of the deposits and bought long-term treasuries, with many purchased when the 10-year yield was at 1.5%. Given the huge drops in bond values, their portfolios have significant unrealized losses as a result, thus pressuring the whole house of cards. What is worrisome here is many banks are in similar situations, with huge unrealized bond portfolio losses. The FDIC reported that at the end of 2022, the total unrealized losses in the industry was $620 billion, versus only $15 billion the year before. Should other banks be forced to liquidate those portfolios, this would lead to huge drops in book value. Let’s get one thing clear though, this only becomes a problem should said bank need to sell assets at depressed prices. It is well known that banks have losses on their bond holdings, but the problem comes when they need to raise capital and sell like SVB had to do. That is when the sharks circle. Don’t forget, the last time the Fed hiked rates aggressively like this was in 1994 and this led to Orange County going under in December 1994. Is this another Orange County moment? This wasn’t your normal bank The FDIC insures bank accounts up to $250,000, but the issue was most accounts at SVB had well over this important threshold. Reports showed the bank had more than $151 billion worth of deposits over the FDIC limit as of the end of 2022. In fact, only 12% of deposits were insured, well beneath the 55% you’ll find from the average commercial bank. Again, this showed that customers were likely to pull out their money quickly at the first sight of trouble, which is what they did to the tune of $42 billion last Thursday. Risks were extremely high A great report by Michael Cembalest of JP Morgan found that SIVB was in a league of its own with a high level of loans plus securities as a percentage of deposits, and very low reliance on stickier retail deposits as a share of total deposits. Bottom line: SIVB carved out a distinct and riskier niche than other banks, setting itself up for large potential capital shortfalls in case of rising interest rates, deposit outflows and forced asset sales. Deposits were another red flag Additionally, looking at SVB’s deposits you’ll find it looked nothing like your traditional bank, with nearly half of the deposits coming from technology companies. Only 7% coming from the private bank looked normal, i.e. the usual retail deposits. The bottom line was their concentration to companies specifically in Silicon Valley helped them on the way up, but greatly hurt them on the way down. It was good till it wasn’t Sure, being a bank to technology, startups, and private equity wasn’t the place to be lately, but from 2015 to 2021 it was a great place to be. In fact, deposits grew from $61.7 billion at the end of 2019 and soared to nearly $190 billion by the end of 2021. Speaking of 2021, deposits exploded 86% that year alone. All in all, that is a tripling of deposits in three years. Not bad. What did they do with most of those deposits? Remember, most went into U.S. Treasuries and other government debt securities—not the best place to be when interest rates rose, as we explained above. But what goes up must come down. Deposits sank from close to $200 billion at the end of March 2022 to $173 billion at the end of last year and to $165 billion by the end of February. This wasn’t just SVB though, as prior to 2022 only 10 quarters saw deposit outflows from US banks over the past five decades. Now there’s been four quarters of outflows in a row. Still, the factors that helped SVB succeed, also expedited its downfall. What are others saying? Mike Mayo of Wells Fargo is one of the most respected banking analysts and he said the issue wasn’t one of deposits, but of the diversity of deposits. Given the majority of their customers were primarily venture-capital firms and they had been under pressure lately, this forced them to slow down on their deposits and burn through cash. This shouldn’t be an issue for larger banks though. “To us, the larger the bank, the more diversified the funding,” Mayo writes. “To us, this is part of the test that the largest banks, i.e., the ones that caused the Global Financial Crisis, are today the more resilient portion of both the banking and financial systems.” Mark Zandi, Moody’s chief economist said, “The system is as well-capitalized and liquid as it has ever been. The banks that are now in trouble are much too small to be a meaningful threat to the broader system.” Lastly, David Trainer, CEO at investment research firm New Constructs said other banks’ financial health and diverse portfolios should help protect them. Yes, all banks are dealing with the loss of value in their bond portfolios, but this only becomes and issue if they actually have to sell those securities. In fact, most banks’ securities holdings are more diversified, much like their customer bases, reducing the chances of trouble. The first domino to fall? Although bank stocks and the financial industry in general had a historically bad week last week, it was worthwhile to note that credit markets remained calm last week. In fact, credit default swaps of large banks didn’t show any signs of stress, suggesting things are contained as of now. Additionally, the US Dollar weakened late in the week. Historically the US Dollar would find a bid under times of extreme stress. Junk bonds were also flat on Friday, quite the opposite of what you’d expect if things were spiraling out of control. Who else is in trouble? Earlier in the week, Silvergate Capital fell as they wound down operations and liquidated the bank. They were one of the largest lenders to crypto companies, an industry that has fallen on hard times lately. Then on Sunday evening it was announced that Signature Bank was also taken over by the government as well. Similar to Silvergate Capital (but much larger), they had heavy exposure and loans to crypto companies. So as of now, two banks went under due to exposure to crypto, while SVB isn’t a traditional bank as we already discussed. Regional banks in general have seen huge losses, but as of the time we are writing this, none of those have gone under. Didn’t anyone see this coming? Some did, but most didn’t is the fact of the matter. Moody’s and S&P both rated SVB Financial at Investment-Grade credit ratings before last week and most analysts had it at a buy or overweight. (Thanks to Howard Lindzon for the table below). In fact, SVB was named one of the Best Banks in 2022 by Forbes, something they made five straight years. Below is straight from their website as of Sunday afternoon. Lastly, SVB’s CEO sold a good amount of stock right before the collapse. Let’s be clear, this was likely a scheduled sell, still, it is interesting. Banks do fail sometimes Although it had been more than 850 days since a bank failed in the U.S., it is important to remember that this does happen from time to time. This nice chart from the FDIC shows how often it happens. Now what? Late Sunday evening, the Federal Reserve, Treasury and FDIC issued a joint statement that all deposits at SVB will be protected. At the same time, shareholders and some debtholders will not be protected. The Federal Reserve is making available additional funding for banks across the U.S. to make sure they can meet all the needs of their depositors. This is a massive step and will help banks avoid the situation that happened at SVB. It will also bolster confidence in the banking system and prevent contagion. This is a very fluid situation and news is coming out seemingly every hour. We will continue to monitor things, but to us things appear to be contained and a full-blown crisis isn’t the likely scenario. Should that be the case, this recent worry could very well be an opportunity for investors to use to before likely higher equity prices in 2023.
Some Good and Some Bad in Small Business Optimism Tue, Mar 14, 2023 Early this morning, the NFIB released the results of its February survey of small business optimism. The headline index rose to 90.9 versus expectations of it remaining unchanged at 90.3. In spite of the bounce, small businesses continue to report some of the worst sentiment of the past decade with the February reading right back in line with the April 2020 low. Diving deeper into the categories of the report, breadth was mixed. Of the ten inputs into the headline number, four were lower month over month, one was unchanged, and the other half were higher. For the most part, these indices also remain in the bottom decile of their historical readings. In today's Morning Lineup, we highlighted how the report's labor metrics have been improving in each of the past four months on an aggregate basis. Plans to increase employment remain healthy in the 77th percentile while the percentage of respondents reporting job openings as hard to fill hit a new record high after rising by a near record 9 points month over month. Although openings were harder to fill, firms also took on more workers. With actual employment changes moving up to 4, it hit the highest level of the post-pandemic period. However, that did clash with hiring plans falling 2 points to match December for one of the lowest readings of the past few years. Likewise, plans to increase compensation are at the lower end of their recent range even while actual observed changes to compensation have improved in the past few months. The same dynamic in which plans are headed in the opposite direction of actual changes can be observed with regards to capital expenditures. Capital expenditure plans were unchanged at 21 last month for the joint lowest reading since March 2021. Meanwhile, actual capital expenditures rose to 60, the highest since March 2020 and credit conditions have improved. Turning to inventories, satisfaction (meaning the net percent of firms reporting if inventories are too low versus too high) fell to the lowest since the spring of 2020. As a result, a net 7% of firms are reporting that they plan to decrease inventories in the coming months. Finally, we would note that on net more firms are seeing lower rather than higher sales in spite of improvements to inflation metrics. The outlook for general business conditions has yet to see any improvement as few businesses report now is a good time to expand. Most firms report now as a poor time to expand due to economic conditions at 36% of responses. The next most commonly credited reason is political climate followed by interest rates, which at 7% match the December reading for the highest since at least 2020.
Where Goes the Fed From Here: Inflation vs. Financial Stability? Posted on March 14, 2023 The Federal Reserve has two mandates – “pursuing the economic goals of maximum employment and price stability.” Over the past year, the Fed has been leaning on the side of the price stability mandate, arguing that the labor market is too tight, i.e., beyond maximum employment. Fed Chair Jerome Powell’s mantra has been: “We must keep at it until the job is done.” A play off the title of Paul Volcker’s 2018 autobiography, “Keeping at it.” Volcker is the Fed Chair renowned for slaying the demon of inflation in the early 1980s. Rich Clarida, Powell’s second in command at the Fed from 2018—2022, said: “Until inflation comes down a lot, the Fed is really a single mandate central bank.” That works fine until there is a looming financial crisis, which the American economy was probably staring at over the past few days after the collapse of Silicon Valley Bank (SVB). My colleague Ryan Detrick wrote a very useful piece on the ins and outs of what happened there. The Fed’s aggressive rate hikes broke SVB There’s a saying that when the Fed hits the brakes, somebody goes through the windshield. You just never know who it’s going to be. As Ryan wrote, a big reason for this crisis was the Fed’s aggressive interest rate hikes, where they raised rates from zero a year ago to more than 4.5% by January. Unfortunately, the speed and size of these hikes resulted in losses for SVB (also due to poor risk management on the bank’s part). The thing is, the Fed has a natural role in maintaining financial stability. At the same time, there is no clear definition for what constitutes a threshold for financial instability, it’s typically not hard to figure out when you’re staring down a crisis, which is what the Fed was facing in September 2008, March 2020, and this past weekend. Thanks to lessons learned in 2008, the Fed acted decisively in 2020 and once again last Sunday – in terms of size, scope, and swiftness of their actions – to prevent a major economic crisis. Arguably, their actions were successful in 2020, and while the situation is still fluid, they seem to have averted a financial contagion this time around. The long and short of it is that the Fed’s inflation mandate ran headlong into its crucial role in maintaining financial stability. Markets are betting that the focus will shift to financial stability This kind of seems obvious, given what happened over the last few days. And investors have completely flipped their expectations for where they think monetary policy goes next. Powell was quite hawkish in front of Congress last week – when he suggested they’re very worried about inflation and could potentially raise interest rates by 0.5% at their March meeting. At the time, we wrote about how it looked like the Fed was panicking. Anyway, investors took Powell seriously enough – pricing in a 0.5% increase in March, a terminal federal funds rate of about 5.6% by the end of this year, and no rate cuts. Four days of crisis really changed things. Markets are now expecting no rate hike in March and expect the Fed to start cutting rates this year. The terminal rate is now expected to be about 4.8%, which is where we’re at right now. In other words, markets believe the Fed is done with its rate hikes. And looking ahead to the end of 2023, markets now expect rates to be 1.1%-points lower than what they expected less than a week ago. This is an extraordinary shift in expectations. And it manifested in an epic move in 2-year treasury yields on Monday – yields fell from 4.59% to 3.98%! That is an 8-standard deviation move, something you should see only in millions of years. In theory. The last time we saw a move like that was in the early 1980s, though back then, yields were north of 10%. Yields are less than half that today, and so the -61 basis point move we just saw in 2-year yields is truly historic. But the Fed still has an inflation problem The latest inflation data indicates that inflation remains elevated. Headline inflation rose 0.4% in February, while core inflation (which strips out energy and food) rose by 0.5%, which was more than expected. Monthly changes can be volatile, so it helps to look at a 3-month average. And that’s not a source of comfort either. Headline inflation is running at an annualized pace of 4.1% over the past three months, while core is running at 5.2%. These are well-off peak levels that were closer to the 10% level. But it’s much higher than the Fed’s target of 2%. What we believe will happen next We believe the Fed is unlikely to surprise markets. More so when there are financial stability concerns. So, it’s very likely the Fed does not raise rates at their March meeting. Unless we get another leak to the Wall Street Journal. In any case, we don’t believe the Fed’s done with rate hikes. Especially when inflation is still too high for their liking. They’ll probably get back on the rate hike path this summer, perhaps in June, if not even earlier in May. But they may not go as far as we thought prior to last week, with rates topping out in the 5-5.25% range (it’s currently at 4.5-4.75%). Crucially, the delay may also buy time for inflation data to fall off by itself and prevent a Fed panic. We know that market rents are decelerating, and that should start feeding into the official data soon. There’s also strong evidence that wage growth is decelerating, which means price pressures in the “core services ex housing” category that the Fed has focused on recently, should also ease.
Stocks Up 22 of Last 29 St. Patrick’s Days Even Luckier Thursday Before Céad Míle Fáilte! The market could sure use a wee bit o’ the luck o’ the Irish this week. Saint Patrick’s Day is the only cultural event that perennially lands in March. Since 1950, the S&P 500 posts an average gain of 0.29% on Saint Patrick’s Day (or the next trading day when it falls on a weekend), a gain of 0.05% the day after and the day before averages a 0.10% advance. More recently since 1994, Saint Patrick’s Day market performance has been improving. S&P 500 has been up 22 times in 29 years with an average gain of 0.76%. In the ten years, since 1950, when St. Patrick’s Day falls on a Friday, like this year, S&P 500 has been green seven times but posts an average loss of -0.01% due to the 2.25% drop in 1989 as the market was stunned by an unexpected jump in PPI and pummeled by heave Triple Witching Day selling. Thursdays before have been greener up 8 of 10 and an average gain of 0.89%. Mondays follow the weekend of parades and revelry have been bleak, down 6 of 10 averaging a loss of -0.08%. This year, St. Patrick’s Day also lands on March Triple Witching Day, which coupled with this week’s banking sector woes and heightened tensions between Russia and the U.S. is bound to create added volatility. If the market can find support this week and next and the Fed presents a more dovish tone the inverse Head & Shoulders (Triple) Bottom could be solidified. May your profits be heavy, and your losses be light.
