May 24th, 2023: Investing in a Narrow Market: Opportunities and Risks

In their recent report, J.P. Morgan strategists have underscored that the stock market this year has exhibited the narrowest breadth it has seen since the 1990s. James Regan, the head of research at D.A. Davidson, also observed that market gains are becoming increasingly concentrated in a smaller number of stocks, a trend that may not be sustainable in the long run. This development is clearly demonstrated in the performance gap between large and small cap stocks, with large cap stocks outperforming small cap stocks by nearly 6%. Moreover, this concentration is even more pronounced within large cap stocks, as the NASDAQ has outperformed the Dow by an astonishing 17%. Drilling down further, large cap growth stocks are currently outperforming small cap growth stocks by a significant 10%.

I believe that the reason for this concentration is that in uncertain economic times, investors tend to prefer large, stable companies with proven track records of success. These companies are perceived to be more resilient during a recession than smaller, riskier stocks. Concurrently, there has been a trend of investors engaging in more speculative trading, hoping to capitalize on the gains of a few high-performing stocks, rather than diversifying their portfolios. Artificial intelligence (AI) is a contributing factor to the increasing narrowness of the stock market. The dominance of technology stocks, particularly those in the large-cap growth category, is benefiting from investor enthusiasm and excitement surrounding AI. The meteoric rise of OpenAI’s ChatGPT further fuels this trend, providing a boost to the tech giants that are rallying around the announcements and potential of AI.

In the current economic climate, large-cap stocks have been thriving due to their cash cow status, pricing power, and the ability to implement cost-cutting strategies. Several large-cap giants, including PepsiCo, Nestle, and Unilever, have raised prices without negatively affecting demand, even amidst recent inflationary pressures. For instance, in the first quarter of this year, these companies reported robust earnings results partly due to their ability to raise prices while offsetting rising costs. Ed Yardeni of Yardeni Research posits that this indicates consumers’ willingness to pay more for these products despite the broader inflationary environment. While pricing power is crucial for a company’s financial health, many large-cap tech companies such as Apple, Microsoft, Amazon, Google, and Meta have experienced plateauing revenues. Nevertheless, they have managed to increase profits by implementing cost-cutting measures and buying back stock, transforming themselves into cash cows that generate consistent cash flow and provide attractive returns to investors. In contrast, small-cap stocks lack these benefits.

Investors are rewarding well-managed businesses with competitive advantages. Over time, these businesses can reinvest their earnings into research and development, marketing, or other strategic initiatives that can further enhance their competitive advantages and drive future growth. These businesses are more likely to maintain their profitability and continue growing, even when the broader economy is struggling, which can help preserve investor capital and generate more reliable returns over the long run.

The major risk associated with this concentrated market is that many companies are facing slowing revenue growth, yet their stocks continue to rise. This is causing the price-to-earnings (P/E) ratios to increase for large cap growth stocks. As share prices continue to climb, while earnings growth lags, P/E ratios have been pushed higher, reflecting a potential disconnect between valuations and the underlying fundamentals of these companies. I remember the days when Apple, Microsoft, and other large technology stocks were trading at 15 P/E ratios, and today those same ratios are in the range of 20-50. Investors may be paying a premium for the shares of these businesses, even though their earnings growth may not be as robust as it once was, which can lead to concerns about overvaluation and market sustainability. Consequently, markets will remain volatile as there can always be a sudden shift in investor sentiment. Richer valuations, as indicated by elevated P/E ratios, may leave these stocks more vulnerable to price declines if future earnings fail to meet investor expectations.

At some point, I anticipate that speculative investors will need to exercise more caution, and there will be an investment opportunity to buy the overlooked mid and small cap stocks. I continue to believe this is one of the best investment environments for both conservative and more aggressive investors. There are investment opportunities everywhere, except for holding cash that earns zero interest. Looking ahead, the next market hurdle will be the debt-ceiling drama this summer. As always, it’s the politicians who will delay the resolution until the eleventh hour. I’ll write more about this topic and the potential market impact in next week’s update.

May 20th, 2023: Navigating the Economic Slowdown and “Growth” Market Momentum

Despite the looming recession and potential U.S. default, investor sentiment continues to be noticeably positive. As of yesterday’s market close, the S&P 500 has bounced back slightly more than 50% from its decline since January 2022. Furthermore, the trading volume for Nasdaq 100 call options saw its highest mark since 2014. Yet, this bullish outlook in growth stocks is seemingly disconnected from the more pessimistic economic data.  This week new data revealed that U.S. consumer confidence in April dipped to a nine-month low due to fears of an impending recession.

The S&P 500’s rebound from a significant downturn suggests that a recession may not be as imminent as feared. This resilience is partially attributed to a corporate earnings season that has, by and large, surpassed expectations. Propelled by robust earnings reports, cost cutting, and enthusiasm for innovative trends in AI, investors have been reallocating towards growth stocks. It’s worth noting that value stocks have underperformed, seeing little to no investor demand. For instance, the Vanguard Value Index has slipped -1.33% this year. Additionally, dividend-paying ETFs like the Schwab US Dividend Equity ETF have performed even worse, falling by -5.75% this year. Consequently, growth stocks have become pricier, while the inexpensive stocks lack buyers. This situation seems eerily similar to 2021, with such a marked disparity between growth and value stocks. I expect these stocks will eventually return to their means, much like they did in 2022. However, I don’t foresee this trend changing in the near future. I also prefer buying and owning growth stocks at a discount, but these stocks are anything but cheap.  

The decline in consumer confidence is visibly impacting the retail sector. Walmart CEO, Doug McMillon, stated on Tuesday that inflation is creating strain among American consumers, with effects varying across product categories. He noted that consumers are prioritizing their purchases, sacrificing certain electronics in favor of essentials. For pricier items like TVs, they are holding out for sales, and cutting back on their apparel and home goods shopping. In a similar vein, Target’s recent earnings report echoed these observations. “American consumers grapple with difficult choices, juggling family wants and needs,” shared Chief Growth Officer Christina Hennington during a post-earnings call, “The looming threat of a potential recession is a major concern for many American families.” Despite the note of caution, both Walmart and Target have actually increased their yearly guidance, thanks in large part to successful cost-cutting measures and improved inventory management. This helps to explain the scenario we are seeing played out across the economy which is the economic data isn’t so hot but investors are still upbeat.

In the weeks ahead, we can expect the focus to shift from earnings reports back to politics. Likely, the politicians will need to come together and delay this major debt issue, with both sides proclaiming victory in the final hour. Once this crisis is averted, investors will shift there attention back to problems like slowing economic growth, stubborn inflation, or a potential recession. Inflation continues to be a wildcard, and considering the Fed’s data-driven stance, the market’s reactions to economic updates will be key. Personally, I don’t rely too heavily on frequently revised government economic reports, as they often provide an incomplete picture of the economy’s health. I find it more useful to listen to management discussions and see what is happening at the business level. 

We’re seeing a market situation reminiscent of 2021, with an economy that’s underperforming and growth stocks carrying the day. Yet, there’s a compelling case beginning to take shape for those keeping a watchful eye on overlooked value stocks, which may eventually swing back into favor. The timing of this shift is more likely to coincide with the Federal Reserve’s interest rate cuts, given that going against the Fed’s actions has traditionally been an unprofitable strategy for investors.

May 13th, 2023: The self-fulfilling market: How short selling is impacting bank stocks

Last week, the Federal Reserve announced another .25% increase to a target rate between 5.00%-5.25%. This is the last time I believe that the Fed will raise interest rates. The next move will likely be a cut. This week, the two key inflation readings came in lower than expected. Consumer prices in April showed a mild slowdown, with a 4.9% year-over-year increase. This marked the tenth consecutive month of declining annual inflation since peaking in June 2022. Unfortunately, for more conservative investors, the current risk-free rate of 5% will likely drop later this year and into next. These 5% rates are great while they last.   

In the meantime, the high interest rates are continuing to wreak havoc on the banking sector. PacWest looks to be the next bank taken over by regulators. PacWest deposits fell 9.5%, or $1.5 billion. The drop came following reports that it was exploring options to bolster its finances. The good news is that the bank for now still has liquidity, and the survival of the bank will depend on whether more deposits leave the bank or not.

The banking crisis would be over instantaneously if the Fed lowered interest rates and the regulators limited shorting in regional bank stocks. Lower interest rates would slow the outflow of deposits, and making shorting more difficult would end the relentless selling of stocks. The set up here is this could become a generational type of buying opportunity if a number of things play out. There is already a number of very well capitalized regional banks with dividend rates of over 6% and only paying out 65% of earnings. The risk is mainly the short sellers.  

I believe that the shorting of financial stocks is causing all this volatility. Short selling, or “shorting,” is when an investor borrows shares of a stock and sells them, betting the price will fall. When the price drops, they buy the shares back at a lower price. Next, they return the borrowed shares and profit from the difference. This can cause a stock’s price to fall because it increases the supply of shares in the market. As more shares are sold (even borrowed ones), the stock’s price can drop due to the imbalance between supply and demand. Additionally, heavy shorting can create negative sentiment around a stock, causing other investors to sell, further driving down the price. The rallying cry for the short sellers is that many commercial loans will default if the economy slows. While this is likely the case, a quick cure to this problem would be lowering interest rates. This could happen overnight with a 1% cut in rates.    

Recently, Bruce Van Saun, CEO of Citizens Bank, provided a real-world example of how short selling could potentially destabilize a financially sound bank. He explained that short sellers could target a bank’s stock, precipitating a decline in the stock price by selling borrowed shares into an already descending market. This action could create an illusion of vulnerability around the bank. This would incite fear among its customers. The fear might trigger a withdrawal of deposits, mimicking the signs of a bank in distress. Subsequently, this panic could lead to a further decline in the stock price as more investors, unable to bear further losses, sell their shares. This cycle would cause more withdrawals. This would complete a self-fulfilling prophecy which benefits the short sellers at the expense of a perfectly healthy bank, its employees, and shareholders. 

In times of heavy market swings, regulators have been known to put the brakes on short selling. For example, in the 2008 financial crisis authorities in countries like the United States, the United Kingdom, and Australia rolled out temporary bans on short selling for financial stocks. This is something they generally save for extreme circumstances when they need to keep the financial markets stable and trustworthy. Nowadays, they could go about limiting short selling by hiking up the borrowing rates on those shares. Even just the mention of a potential limited ban could be enough to halt coordinated short selling attacks.

In the next few months, we will continue to deal with rampant short selling and debates over the debt ceiling.  All of these are putting a serious strain on our financial system and threatening to put the brakes on the economy. The government and the Federal Reserve have their work cut out for them as they try to navigate and mitigate these self-fulfilling prophecies. With some well-placed agreements, they could bring about a far more stable market. But until that happens, we can expect to see the markets continue their daily rollercoaster ride, responding to every twist and turn in the road towards these solutions. So, while it’s a challenging landscape, there’s still the potential for positive change if the right actions are taken. If not, there is going to be a short-term set up that could open up some very interesting opportunities in the banking sector. 

May 6th, 2023: Taking a balanced approach to the debt ceiling drama 

I’ve had quite a few conversations with clients regarding the uncertainty surrounding the debt ceiling situation. The U.S. government has dealt with debt ceiling issues in the past, with varying degrees of success. Since 1960, Congress has acted 78 separate times to permanently raise, temporarily extend, or revise the definition of the debt limit – 49 times under Republican presidents and 29 times under Democratic presidents. The debt ceiling limits how much money the federal government can borrow to pay its bills. As we have seen in recent news, it has become a significant point of contention in Washington. It’s more concerning that the government spends more than it takes in and that issue is ongoing. 

The political grandstanding is frustrating. Considering the extreme polarization in Washington, any outcome is possible this time. It’s important to remember that predicting the market’s next move can be challenging. It sometimes behaves counter-intuitively. As strange as it may sound, the market could fall initially due to a shutdown and then rally in anticipation of reopening. This is similar to what we witnessed during the economic shutdown in 2020.  If the deadline was missed, I would expect there would be an initial market shock and then at some point that the market would rally when the narrative changed that the debt ceiling would eventually be raised. 

Personally, I’m more concerned about the stress being placed on the banking system due to the massive amount of money flowing out of banks and into money markets. Eventually, the Fed may be forced to cut rates to bail out the bankers who have mismanaged their assets and liabilities. The significant capital losses in bank stocks might seem like a buying opportunity; however, the difficulty lies in the fact that stock prices can plummet to zero overnight. We have seen a few banks taken over by regulators at the first sign of trouble. In financial stocks there are no “meme” rallies rescuing banks on the brink of bankruptcy. That only works when the regulators don’t get involved and capital can be raised by issuing new shares. The discount in bank stocks is warranted due to the risks associated with customers moving money to safer banks. Banks that have managed their portfolios well haven’t experienced much of drop in value. Those that are down the most offer potential returns of plus 50% if they don’t get taken over by regulators, but there’s also the risk of their stocks going to zero.

Investors are now paying a premium for companies with consistent earnings and revenue. We have learned that companies can rally if they aren’t experiencing revenue growth as long as they don’t lose money.  The businesses that are buying back stock and/or cut expenses have done the best. On the other hand, companies with substantial debt or an inability to buy back stock haven’t fared as well.

In light of the current environment, I’ve been managing your investment portfolio with diversification and risk management in mind. This balanced approach allows your investments to withstand economic storms like the one we’re currently facing. While it’s natural to feel concerned due to bank failures and the potential government shutdown, I have confidence that taking a long-term view and not focusing on the day-to-day moves of 1%-2% is the best way to navigate market fluctuations. The real risks regarding the deficit will play out over time in the form of higher inflation and interest rates. The government will try to slowly inflate their way out of this problem.  The likely outcome is that politicians will continue to kick the can down the road. Unfortunately, there isn’t going to be quick fix to this deficit problem. The focus continues to be on the long-term success and resilience of the businesses we are invested in. This approach will help us remain proactive in the face of these uncertain economic times. 

April 15th 2023: Optimism amid Uncertainty: US economy is slowing but outlook remains positive 

The US economy continues to be on a generally healthy footing. On the JP Morgan earnings conference call, CEO Jamie Dimon said that consumers are still spending and have strong balance sheets, and businesses are in good shape. As I wrote last week, financial conditions will likely tighten as lenders become more conservative. It is still unclear if this will cause a recession. The Fed is forecasting a recession, and there are clear signs of a slowdown in the recent retail data. Shoppers are pulling back on purchases of items such as vehicles, furniture, and appliances amid climbing interest rates. The bad news is layoffs are rising quickly and no longer just at technology and media companies. CNBC noted that announced layoffs are 396% above year-ago levels. The layoff announcements this year have helped to push stocks higher because it’s been part of the following market narrative: Inflation is too high → the Fed is raising interest rates → interest rates are slowing consumer spending → a recession eventually hits, and companies cut costs → there will be a drop in revenue, but profits will not fall as much because of lower costs → if there is a recession, the Fed will then have to cut rates → growth stocks rally because rates fall, and economic growth returns.

On the inflation front, there was some positive news this week with the producer-price index falling 0.5% in March from the prior month. This was the largest monthly decrease since April 2020. However, it’s important to note that financial conditions remain strong, and this could continue to drive inflation higher. One factor that contributed to the current state of strong financial conditions is the amount of money that was printed, which has increased the money supply and led to higher prices. Additionally, there are other signs of inflationary pressures, such as oil prices rising 25% over the last month and the jump in speculative cryptocurrencies this year. It remains to be seen how long these trends will continue and how they will ultimately impact the broader economy. Given all the economic reports over the last month, the market expectation is that the Fed will raise rates by 0.25% for the final time at their next meeting in early May. This is part of the reason why growth stocks have continued to rise. Over the last 40 years, during the period between the Fed’s final rate hike of a tightening cycle and the first rate cut in the following easing cycle, the stock market averaged an 11% return, while bonds returned an average of nearly 7% (source: Bloomberg).

I believe that investor expectations are on the high side for technology companies in a slowing economy. This sector will continue to be the most volatile. There is a risk that inflation remains high because of geopolitical tensions, higher energy prices, and worsening relations with China. I’m continuing to be prepared for a broad range of economic outcomes. This market continues to offer suitable investments for almost every type of investor with different risk tolerances. There is a minimum 4-5% return in money markets and treasuries for lower risk investors, and for higher risk investors, high-priced large-cap growth equities have been on an upward trend.

While the tech market has been very strong, it has been a narrow market overall this year. This means that the performance of the majority of the market is driven by a small group of large growth stocks, rather than a diverse range of stocks. The current stock market has been exhibiting characteristics of a narrow market, with a few large growth companies having a disproportionate impact on the market’s overall performance. As a result, the performance of these companies can heavily influence the performance of the overall market.

I expect the headlines will continue to be dominated by the potential for a recession later this year. It’s been a saver’s market for people that have money to buy stocks and bonds. For people with high debt levels paying the high costs of interest, they will likely be the ones that fall behind in this economic environment. While there are certainly risks and challenges facing the US economy, there are also reasons for optimism. Consumers and businesses remain in good shape, and policymakers have demonstrated a willingness to take action to address potential issues. I expect the Fed to cut rates at the first signs of a slowdown. This is why the US economy is poised for a quick recovery if this scenario plays out at the first sign of a recession.

April 8th, 2023: Money Market Funds Record Inflows: What It Means for the Economy

Over the past few weeks, the banking industry’s ongoing turmoil and the quest for higher yields have sparked a surge of interest in money market funds. According to the Investment Company Institute, this has resulted in over $300 billion flowing into these funds, pushing assets to a record $5.2 trillion, surpassing the pandemic peak of $4.8 trillion. In contrast, deposits in all commercial banks have decreased by $1 trillion from $18.3 trillion to $17.3 trillion. What could this mean for the economy?

Treasury Secretary Janet Yellen has identified money-market funds as a potential source of risk to the banking system since the funds cannot be recirculated into the economy as loans. JPMorgan Chase CEO Jamie Dimon warned that the banking crisis has increased the likelihood of a US recession this year. “We’re seeing people reduce lending, cut back a little bit, and pull back a little bit,” he said. Although stress in the sector does not always cause a recession, he warned that “it is recessionary.”

There are indications that a slowdown is on the horizon. The Atlanta Fed’s GDP tracker shows a slower growth rate of only 1.7% in the first quarter, compared to an estimate closer to 3.5% less than a month ago. Small businesses are under the most pressure. Yesterday’s jobs report showed the lowest pace of growth in more than two years, indicating that the labor market is cooling slightly. Startups from venture capitalists raised only $37 billion in the first quarter, the lowest in three years. It’s evident that investors are adopting a more cautious approach due to the uncertain economic conditions. There has also been a significant drop in market trading volume, over 30%. The stock market has become very narrow, with only a few highly volatile stocks appreciating while the rest struggle to make any real gains.

There are several reasons why money leaving the banking system can lead to a recession. When money-market funds receive deposits, the funds are invested in short-term, low-risk securities such as government bonds, rather than in longer-term loans, mortgages, or other types of credit. This decrease in lending activity can slow down economic growth and lead to a recession. Banks have less money to lend when this money is withdrawn from the banking system, leading to a decrease in the credit supply. This, in turn, can result in higher interest rates, making it more expensive for consumers and businesses to borrow money. As a result, spending and investment may slow down, leading to a decrease in economic activity. Given the banks’ investment losses, they may tighten lending standards, making it more difficult for businesses and individuals to access credit. This can lead to a decrease in investment and an increase in loan defaults, which can further harm the banking system.

Despite all of the ongoing negative headlines, the good news is markets have remained resilient.  As I mentioned a few weeks ago, investors have shifted back towards dividend-paying stocks, and large-cap growth stocks have seen the highest returns as long rates continue to fall. The expectation is the Fed will cut rates early next year and dividend stocks will once again be the only place to generate a higher income. As we approach earnings season, the market narrative is expected to shift towards how companies’ cost-cutting measures are helping to boost profits during these challenging economic times. However, the impact of reduced lending activity due to falling deposits in banks and higher money market deposits could potentially hold back economic growth. 

April 1st, 2023: Daily Options Trading: The New Meme Stock

As we review the stock and bond markets this week, it appears that investors are already pricing in the recovery even before the supposed recession hits. Market volatility has been well over 1% in either direction on any given day. I believe this is largely due to the increased trading volumes of shorter-dated options contracts. These options, also known as zero-day-to-expiry options or 0DTE options, have replaced “meme stock” investing and now account for almost 50% of all options traded.

While well-timed daily options can produce 1x, 2x, and even 3x daily returns, this week those daily options hit well over 5x. For example, let’s say that today is Friday, and the current price of the SPDR S&P 500 ETF Trust (SPY) is $400. An investor interested in trading daily options might consider buying a 0DTE call option on SPY with a strike price of $402. The premium for this option might be around $0.50, which is a cost of $50. If the price of SPY rises above $402 before the end of the trading day, the investor would make a profit on the option. For instance, if SPY rises to $406 by the end of the day, the investor would be able to exercise the option, buy shares of SPY at $402, then sell them on the market for $406, earning a profit of $350 ($400 minus the $50 premium paid for the option). The leverage created by this speculator is that at a $50 cost is equivalent to a $40,000 position (100 shares x $400) in SPY. In most cases, the speculator is buying multiple contracts. For example, following the example above with only $1,250 (25 contracts at $50) in a small brokerage account, a day trader can be long $1,000,000 in the SPY (25 contracts x $40,000) if the options move into the money, which would be a market move from $400 to over $402. At this point, every dollar move up over $402 in SPY would be a $2,500 profit (25 contracts x 100 shares). I realize that this example might be confusing, and it would be for most people trading these options, except that trading platforms such as Robinhood have gamified trading with visual graphics that help users easily understand profit and loss scenarios.

On the other hand, if the price of SPY does not rise above $402 by the end of the day, the option would expire worthless, and the investor would lose the $0.50 or $50 premium paid for the option. In my example, the day trader would lose the entire $1,250. This is the risk associated with trading 0DTE options – they are highly speculative and can result in significant losses if the market does not move in the expected direction. The intra-day moves of moving up and down over 1% are now the norm. The Reddit day traders that started the meme craze are now all over these options, and the masses are now being educated on daily options.

You might be wondering what could possibly go wrong because in these markets, something this speculative eventually breaks. It is essential to note that the risk of a fat-tail event is increasing. Fat tails refer to the extreme ends of the distribution being hit and are becoming much more common, particularly when the market moves in one extreme direction. As such, I would now be very hesitant to “sell” any put options to someone betting on a fat-tail event. For instance, if markets get overbought, and the SPY trades to say $420, it could correct back to $400 easily in a day. This $20 daily change will wipe out the put sellers and be a potential 36x return for the put buyer. Without going into the math in this example, a move from $420 to $400 would result in a $45,000 profit on 25 contracts ($18 point move down in the money x 25 contracts). The seller of this put would be wiped out. The danger thus lies with the seller of these options. The losses are limited for the buyer but unlimited for the seller who takes the other side of this bet. This is why either overpriced or underpriced markets going forward have much more potential to correct back to equilibrium in only one day.

You might also be wondering how these options are impacting your investments. They are starting to have more and more of an impact. For example, I have observed that the once sleepy stock Berkshire Hathaway is now fluctuating over $5 on Fridays, with up to $3 movement in the first and last 15 minutes of trading. This is likely due to the fact that Berkshire only has weekly options expiring on Fridays. If daily options were available, the stock could move over $6 a day. A few weeks ago, the stock moved almost $10 down, and there was no news. These trading points will also help to create buying opportunities. Long-term investing is more important than ever with the increased popularity of daily options. While these options can provide the potential for large short-term gains, they are also highly speculative and come with significant risks. The high volatility associated with daily options can lead to significant price swings in a short period, which can be tempting to react to and adjust investment strategies in response. However, focusing on short-term price moves can be detrimental to long-term investment goals, as these moves can be unpredictable and influenced by a variety of factors, including speculation and market sentiment. Instead, successful investing will depend even more on focusing on a well-diversified long-term investment strategy. Our investment approach can help to mitigate the risks associated with daily options while still providing the potential for long-term growth and stability.

I expect the popularity of daily options may eventually lead to a Congressional hearing to educate politicians on why market volatility got out of hand on that one down day that wiped out all the put sells. It’s also possible that the fat tail is to the upside. In this case, there wouldn’t be any hearings because nobody complains about up markets. The scenario that is most likely to play out would be a spike up followed by a spike down. This way, everyone loses in the end, like all the ill-timed investors in the meme stocks in GameStop and AMC. We are not there yet, but by the looks of the gaining popularity of these options, that day is fast approaching.

March 25, 2023: Interest rate divide: market expectations vs. Fed projections

This week, the Federal Reserve announced its decision to raise its key short-term interest rate by another quarter percentage point. The Fed is anticipating another quarter-point increase to a peak range of 5.00%-5.25%. The current Fed expectation is rates will fall to 4.30% next year. However, the market expectation is the Fed is going to have to cut rates sooner to fight the recession that it helped create. The bond market is pricing in a 1.5% cut in rates within the next two years. This will drop rates to around 3.5%. There is clearly a disconnect between the Fed and the bond market. I believe the bond market has it right and the Fed will cut rates sooner than expected. The bond market has been one step ahead of the Fed the entire time. Even the stock market never sold off much when the Fed warned of higher rates. 

While the Fed remains confident in the overall stability of the financial system, it acknowledges that recent developments are likely to result in tighter credit conditions for households and businesses, which will weigh on economic activity, hiring, and inflation. In their statement released after the two-day meeting, Fed officials acknowledged recent strains in the nation’s banks and said it will soften the economy. 

The Fed plan all along was to push rates up until something broke. Many market strategists have urged the Fed to pause rate hikes, as they have undermined the value of treasuries and other securities, which are a critical source of capital for most US banks. The collapse of Silicon Valley Bank was a stark reminder of how quickly a liquidity crisis can arise. Despite this, Fed Chair Powell defended the decision to raise interest rates, stating that the crisis was the equivalent of a rate hike and perhaps more significant. He added that “it’s too soon to tell” how much stricter bank lending will hobble the economy and tame inflation, but said it could be more significant than expected, and the Fed “may have less work to do.”

On a more positive note, the yield curve is starting to flatten, and yields are dropping. This should help to alleviate some of the losses on bank balance sheets. It is surprising that many of the Federal Reserve members are also from US commercial banks, and they didn’t adjust or warn other banks to shorten maturity. A few banks such as JP Morgan, PNC, and M&T Bank correctly anticipated higher rates, but many other banks locked in low rates way too soon. 

On Friday, Deutsche Bank’s stock dropped as investors worried about which bank could be next to fall. There has been a flight to move money out of the banking system. The troubles overseas look much worse than what is happening in the U.S. Most of the money from the banking sector is going into treasuries and money markets. The two-week increase in outstanding U.S. money market funds had the largest increase since April 2020. Also, the Fed’s balance sheet just expanded the most for a two-week period since May 2020. Bank profits will likely take a big hit in the next few quarters. Bank stocks have lost so much value that they now look much less vulnerable. The large-cap growth sector has been the most resilient. The hardest-hit area is small caps, which are the most sensitive to a recession. If the market cycle repeats, small caps are setting for big gains if there is a recession. The trend continues to be that Investors are buying growth stocks in anticipation of future interest rate cuts by the Fed. There is also a strong case to buy dividend-paying stocks once again as interest rates fall. In the meantime, the problems at Deutsche Bank need to be resolved just as they were last week when UBS took over Credit Suisse. Hopefully, the German government can put together a plan over the next few weeks if that stock starts to drop more in value. 

March 18, 2023: The Fed’s Interest Rate Hike Exposes Banking Crisis

I was concerned that if the Fed increased rates beyond 5%, it could harm the economy severely. However, I didn’t fully understand how or when this would happen. The answer became apparent when a few greedy bankers bought long-duration fixed-income assets or took on crypto depositors in search of a higher return. As a result, when the Fed increased interest rates at its fastest pace in history, these securities declined in value, causing a banking crisis. This situation reminds me of Warren Buffett’s famous quote, “A rising tide floats all boats….. only when the tide goes out do you discover who’s been swimming naked.”

The Fed did not anticipate this banking crisis. Throughout my career, it has been the Fed that created every market bubble with easy monetary policy, eventually market speculation forced the Fed to pop the bubble.  These bubbles are created when interest rates go down and popped when interest rates go up. One would expect that some of the portfolio managers at these banks would have known where we were in the interest rate cycle. The recent events have also highlighted the importance of having experienced risk managers on board at banks. Silicon Valley Bank, for instance, did not have a chief risk officer for much of last year, and many board members lacked sufficient banking experience.

In a highly volatile market this week, the 2-year treasury fell from 5.2% to 3.8%. The narrative of the market has shifted from fighting inflation to a banking crisis. Suddenly, inflation doesn’t matter as much if bankers are losing money. There has been debate on whether this rescue constitutes another bailout of bankers. Eleven of the biggest U.S. banks announced a $30 billion rescue package for First Republic Bank in an effort to prevent it from becoming the third bank to fail in less than a week. The banks are likely returning the $30 billion in deposits that First Republic Bank lost over the last few weeks. This backstop was not financed with taxpayer money, but the risk is that if this dam doesn’t hold, the Fed will have to step in to secure the entire system. In my opinion, this is a bailout because interest rates are dropping and the yield curve is flattening and this will help to relieve the pressure of the unrealized losses on the bankers balance sheets.  

It is likely that the repercussion of this crisis will be tighter lending standards, as banks with unrealized losses are unlikely to take out any risky loans. Many banks have done a great job of managing the rising interest rate environment, and they are the ones that will benefit the most when depositors seek out larger “too-big-to-fail” banks.

Despite the market being under stress in recent weeks, some areas of the market have held strong. Technology has become a safe haven, and cryptocurrencies have rallied the most.  The lower quality investments have done the best, which actually makes perfect sense. As we learned over the last few years, these investments are the most interest rate-sensitive and don’t trade on fundamentals. They rallied for the sole reason that interest rates have fallen. Some analysts speculate that the Fed might be compelled to lower interest rates to assist banks in recapitalizing and resolving unrealized losses on their balance sheets, which would end this banking crisis. However, the Fed is expected to raise rates 0.25% next week, but cut rates sooner than expected.   

Looking ahead, the economy will likely slow faster than previously anticipated. The biggest risk is that if inflation does not drop, the Federal Reserve will be forced to decide whether to fight inflation with higher rates or bail out the bankers. With the recent drop in commodity prices, inflation is cooling, but it might not fall as fast as expected. The Federal Reserve’s next more will be to try to talk inflation down while signaling that they will no longer be raising rates. 

March 11th, 2023: SVB’s failure: A Wake-up Call for the Federal Reserve 

I had been wondering when the Fed would receive its wake-up call that they were pushing interest rates too high. The Fed’s plan all along was to raise interest rates to fight inflation until something broke. That call came on Thursday when Silicon Valley Bank (SVB) announced that it was trying to raise $2 billion in capital due to losses experienced on its balance sheet and rising customer defaults. SVB, a prominent lender in the world of technology start-ups, collapsed when its customers panicked, forcing the federal government to step in. The 16th largest bank was taken over by the Federal Deposit Insurance Corporation, making it the second-largest failure in U.S. history and the largest since the financial crisis of 2008.

Fueled by successful start-ups flush with cash from venture capitalists, SVB invested a majority of the customer deposits in search of higher returns, heavily investing in long-dated Treasury bonds and mortgage bonds that provided stable returns when interest rates were low. Unfortunately, the bank invested significantly in bonds just before the Federal Reserve began increasing interest rates slightly over a year ago, and did not account for the possibility of quick and significant rate hikes. As a result, as interest rates increased, these investments lost their attractiveness compared to newer government bonds that offered higher interest rates. They also had trouble finding a buyer because many of the start-ups that they were lending too were experiencing financial trouble due to the slowing economy. 

The situation may have been manageable if the bank’s customers did not demand their funds back all at once. Over the last few months, clients of the bank started to withdraw a larger portion of their deposits. As a result, the bank was forced to sell off some of its investments to meet redemption requests. In a surprising announcement on Wednesday, the bank revealed that it had suffered losses of nearly $2 billion as it was all but compelled to sell off some of its holdings to pay those redemption requests.

The bond market reaction to this bad news was to lower interest rates. The recent failure of SVB highlights the fact that the US banking system may not be as strong as we previously thought. If well-capitalized banks cannot survive in a 5% interest rate environment, then the Fed’s ability to fight against inflation will be severely limited. I believe that a narrative change is needed to shift people’s focus away from inflation and towards stabilizing the financial system. Controlling the unrelenting market volatility in interest rates and equity prices is just as important as lowering the inflation rate. Consumer prices are no longer rising as fast as last year, so we are much closer to a pivot by the Fed.

The big question now is whether this is the start of a much larger problem, as investors turn their attention to other financial institutions after the Fed’s recent steep rate hikes. There is a risk of contagion from SVB in smaller local banks, and it would be prudent for people to reevaluate where they are holding their money and the amount they are holding. If you have your money at a small local bank, I would recommend keeping bank deposits below the $250k limit. For those wondering about their investments held at TD Ameritrade, they are a member of the Securities Investor Protection Corporation (SIPC). Securities in your account are protected up to $500,000, which includes a $250,000 limit for cash. Additionally, TD Ameritrade provides each client $149.5 million worth of protection for securities and $2 million of protection for cash through supplemental coverage provided by London insurers. Investment companies are a much safer place to keep your cash.

While there is no exposure to regional bank stocks in your portfolio, they are looking much more interesting. I expect the larger banks will once again be the biggest beneficiaries of people seeking safety. For example, JP Morgan’s stock was up yesterday because they have done a much better job managing their fixed-income portfolio. The larger banks will continue to push out the smaller less diversified banks. 

Additionally, it’s worth noting that while the failure of SVB may cause some short-term disruptions in the financial markets, it is not indicative of a systemic issue in the US banking system as a whole. The US banking system is generally considered to be one of the strongest in the world, with a high level of regulation and oversight designed to prevent systemic risk. SVB in particular had mismanaged its portfolio and was not a diversified bank. Many of the customers were start-up technology companies that were running into financial problems after the technology bubble burst. 

The major unknown is what will be the impact on private equity firms and other customers of SVB. Hopefully, the government does the right thing and helps make whole all the customers of SVB. The failure serves as a wake-up call for the US banking system and the Federal Reserve, highlighting the potential risks of rising interest rates and the importance of maintaining a stable financial system. While there may be some short-term disruptions in the financial markets, it is important to remember that the US banking system is generally considered to be strong and resilient, with a high level of oversight and regulation. Looking ahead it will be interesting to see if investors jump back in immediately after prices fall, because now they have yet another chance to buy at lower prices. The good news is the Fed got it’s wake-up call this week and investors will welcome a less aggressive Fed.