March Madness

April 3, 2023

By Mark Oelschlager, CFA

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At the end of 2021, the Dow Jones Industrial Average closed at 36,338, and the career scoring total of LeBron James stood about 60 points lower, at 36,279.  (In defense of LeBron, the Dow had a head start of more than a century.)  Shortly thereafter, James passed the Dow for good (at least for the time being), and about a year later, on February 7 this year, he eclipsed a more-relevant mark: the all-time NBA scoring record.  When Kareem Abdul-Jabbar retired in 1989 with 38,387 points, his record was thought by many to be unbreakable, and in fact it stood for decades.  It took a kid from Akron to break it.  What basketball aficionados are quick to point out is that the irony of James holding this record is that scoring isn’t even his strongest skill!  Rather it’s his passing ability – a function of both his ability to see a play developing and his unselfishness.  It’s this quality, much more than his scoring, that has allowed James to elevate many otherwise mediocre teams to contender status.

 

In the first quarter, like a LeBron James team, the market was pulled higher by a small number of players, with seven of the eight largest stocks in the S&P 500 advancing between 17% and 90%.  This turned what would have been a 1% return for the index into a 7% gain. The quarter was also marked by speculative issues rising from the ashes.  Companies possessing undesirable attributes (such as being unprofitable) that normally augur poor stock performance saw their stock prices bounce back from a disastrous 2022.  Our sense is that this will prove fleeting.  The performance of stocks in general has been remarkable so far this year, considering the frustratingly slow progress on inflation and a banking crisis that saw two major banks fail.

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For much of the quarter the focus was on the Federal Reserve (Fed) and its battle against inflation.  The market seemed to be positioning for the end of the Fed’s interest rate hiking cycle.  But inflation has proven to be stickier than expected, and unemployment, which hit a 53-year low, slow to rise.  This has forced the Fed to continue its tough talk on inflation and to forecast rates higher for longer.  The thought that keeps popping into my head is that, while everyone is hanging on every data point in hopeful anticipation that it could end the Fed’s tightening cycle, there seems to be insufficient attention being paid to the actual effects that the cycle will ultimately produce.  As Milton Friedman used to say, monetary policy works with long and variable lags.  In other words, it takes time for changes in interest rates (in either direction) to affect the economy, and it’s hard to know when those effects will occur.  If history is any guide, we haven’t yet seen all the effects of the Fed’s interest rate hikes.

 

Interestingly, just as many market participants were beginning to write off the possibility of a recession, a financial crisis popped up, leading to the failure of Silicon Valley Bank (SVB) and Signature Bank, and the rescue of European giant Credit Suisse at a steep discount by UBS.  The 16th largest bank in the US, SVB had an undiversified deposit base, catering mainly to venture-capital-backed startups.  When the funding market for venture capital started to dry up, these young companies had to tap their bank deposits to fund operations.  In order to fund these withdrawals (banks don’t just have all their deposits sitting in cash at the ready; they use deposits to make loans or buy bonds), SVB had to sell bonds.  Even though many of these bonds were issued by the US Government and therefore considered safe from a credit standpoint, they had fallen in value since being purchased by the bank when interest rates were extremely low.  Many media accounts mistakenly blame these losses on the Fed and its interest rate hikes, but the losses had more to do with the rise in long-term interest rates, which the Fed doesn’t control.

 

If SVB didn’t have to sell these securities, it wouldn’t have had a problem.  But the needs of its depositors necessitated the sales, which generated losses, which eroded the bank’s capital.  Customers recognized that it was only a matter of time before the well ran dry, and they rushed to withdraw their cash – a classic run on the bank.  Exacerbating this run was the fact that a high percentage of the bank’s deposits (remember, these are mainly the deposits of companies) were uninsured because they were held in accounts that exceeded the FDIC-insured cutoff of $250,000.  After the collapse, the regulators stepped in and guaranteed all deposits of SVB, but they have not done so for the deposits of all banks.

 

Financial stocks sold off, as investors feared more casualties on the horizon.  It is difficult to know how this will play out and how many more failures there will be.  Much of it depends on human behavior and the reaction of regulators, both of which can be hard to predict.  There were certainly idiosyncratic factors that made SVB and Signature more vulnerable than the average bank, but it’s also true that many banks are dealing with the same issues – shrinking deposits (due to more attractive yields elsewhere) and losses on bond holdings.  Another thing to consider is that the market is trying to sort out not only which financial institutions have liquidity risk, but which ones are facing pressure on profit margins and for how long, given current operating conditions, and the prospects of heightened industry regulation after the dust settles.

 

During the turmoil in March, there was a flight to quality with investors rushing into bonds, pushing their prices up.  This is an odd or ironic twist in that the crisis, which is partly driven by bond prices having fallen, has caused bond prices to rise, which relieves at least some pressure on the banks.

 

In our opinion, the banks most at risk are the ones that have grown the fastest (either on the asset or liability side) in recent years, as they are likely to see the greatest decline in deposits and have the greatest losses in their portfolios.  Our bank holdings generally don’t fall into this category, but their stock prices have still taken a significant haircut.  In the aftermath of the failures, the Fed started a Bank Term Lending Program, offering loans to banks who need liquidity.  This should help.

 

They say that stock market history doesn’t repeat, but it rhymes, and this crisis is a perfect example.  While everyone had their eye on credit, since that’s usually where financial problems start, this time the problems originated on the liability side of banks’ balance sheets, compounded by an asset-liability mismatch (the duration of assets not matching the duration of liabilities).  Speaking of credit, the problems at the banks should assist the Fed in tightening credit and slowing the economy.  This is because with the banks worried about funding (their deposits are shrinking, and they’d rather not have to sell their underwater bond holdings), they have less capital available to make loans.

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Once again, a Fed rate hike cycle has led to dislocation, this time about one year after the Fed started raising rates.  Given the magnitude and speed of the Fed’s hikes over the past 13 months, and the lag with which monetary policy works, we believe more trouble lies ahead.  We are managing our portfolios with this in mind, balancing capital preservation with the need to take risk to grow your investments.

 

Happy Easter, everyone.

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Mark Oelschlager, CFA  

Oelschlager Investments 

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