April 13, 2023

DUDE, WHERE’S MY MONEY

by Adam J. Morgan, CFA, CMT

The very same place that set our economy ablaze with innovative technologies that would change our lives forever and inspire the longest bull market in our nation’s history also sparked a financial wildfire this past month that sent embers around the world in seconds before finally being smothered, right here in Raleigh, NC. The recent bank failures of Silicon Valley Bank, and others, sent shockwaves through the global financial system as bank customers and the rest of us wondered if this was 2008 all over again. It is is not. But it’s not 2017, either.

The failure of Silicon Valley Bank was due to poor management, plain and simple. The bank’s clients had the ability to withdraw large sums of money at any time using an app on their phones and yet the bank invested much of that money in long-term bonds marked as Held-To-Maturity (HTM) securities. HTM is an accounting classification designated for assets that are not intended to meet short-term cash needs and therefore don’t need to be priced daily. Recent interest rate increases have reduced the value of those assets such that when the customers attempted to withdraw their deposits, the bank couldn’t meet the demand without realizing big losses. It’s akin to having to sell your house today to buy groceries tonight. Depending on the day, your effective grocery bill could be astronomic. You can rest assured that the Holding family will fix this problem now that First Citizens has established a foothold in Silicon Valley. They may also convince a few bankers to trade in their Allbirds for a necktie and a pair of wingtips! #There’sANewSheriffInTown    

The problem that faced these banks was not the same problem that we grappled with in 2008. In 2008, the banks’ leverage ratios made every problem exponentially worse. That problem does not exist today. However, it is worth noting how this fire caught. It wasn’t hard for a community of otherwise intelligent entrepreneurs and businesspeople to believe that the bank might be failing. Why? Because these are people who are seeing firsthand how the business landscape is becoming increasingly more challenging. Everyone is well aware that lending standards have tightened, the cost of borrowing has soared, and the cost of labor has skyrocketed. So, when word spread that the banks might be in trouble, it was believable.

This speaks to the fact that our economy has lost confidence. Prior to the pandemic, economic conditions were about as good as they get. The unemployment rate was the lowest since 1969, inflation was nearly non-existent, companies were increasing capital expenditures in masse, and real wages for many Americans in every income bracket were rising. Equity and real estate markets followed suit. Fast forward a few years and our economy is slowly petering out like a late-night campfire. Optimists point to a resilient labor market as a sign of strength, but in my view that’s the dog that hasn’t yet barked. In order to keep runaway inflation at bay, the Federal Reserve must reduce aggregate demand which in turn is certain to put people out of work. We are already seeing the early signs of weakness as layoffs are spreading. In my view, we are very likely to experience a recession this year or next. And the recent bank fire didn’t help. After all, would you be as willing to lend money after nearly watching “It’s a Wonderful Life” play out in Silicon Valley? This fire surely slowed an economy already slowing.

It’s important to keep in mind, however, that the stock market and the economy are not the same thing. The stock market is a forward-looking, price-seeking entity that is willing to look beyond the Valley to the next peak, as long as that peak is visible. Despite the bank failures, the market has rallied because there is now a consensus belief that the Fed will announce a “pause” from raising interest rates at their next meeting on May 2nd. If true, that brings the next peak a bit more into focus for many investors.

Personally, I don’t believe that we’re out of the woods just yet, but I am somewhat comforted by the strength of recent market-price action. We’re now 15 months and 15% away from all-time highs on the S&P 500. That doesn’t happen often. In fact, since the 1980s, it’s only happened twice, both times during recessions (’01 and ’08). So, the recession is not sneaking up on anyone and the S&P 500 just completed the first quarter of the year by posting a gain.

I’m worried that inflation will erode corporate earnings slowly over time and the bulls of late will reverse course when that reality is realized. I’m worried that years of ultra-low interest rates has trained too many to believe that all markets recover in a “V-shaped” pattern, instead of grinding sideways for years as those who aren’t invested properly lose purchasing power by failing to generate returns that outpace inflation.

The weight of the evidence, as we see it, leaves us neither bullish nor bearish. We believe that we’re in a market where companies that can produce consistent earnings will do well and those who cannot produce will be punished. In 2008 as in 2017, one could more easily evaluate the health of the market by following the obvious trend of the broader index. The ability to navigate through a recession as well as all the challenges facing businesses today should help separate the winners from the losers. For that reason, we continue to favor higher quality stocks that have displayed an ability to grow free cash flow as well as companies that are comfortably paying a consistent dividend. Furthermore, we have significantly reduced our exposure to lower credit quality fixed income in favor of investment grade fixed income now paying an attractive yield. For us, this means that we’re likely to trail the broader index if we’re dead wrong and heading into a strong bull market. For the time being, that is a risk we are willing to accept.

But we’ll be keeping our eye out for opportunities. After all, recessions are like wildfires in that they cause destruction in their path while also creating a fertile landscape for new life to grow. —A. Morgan