The S&P 500 plunged -4.55% this week with Friday's close at 3,861.59.
The index traded fairly quiet most of the week until all hell broke loose after hours on Wednesday and into Thursday's trading when a quasi "gray swan" emerged and gave birth to a potential crisis of confidence across the banking sector.
Warren Buffett has a great quote:
"Only when the tide goes out do you discover who's been swimming naked".
Put differently, "bear markets" have a way of bringing all of the worst-run companies front and center, and the bear eventually shines a spotlight on the most incompetent of "C-suite" leadership. The latest example took center stage after the bell on Wednesday as Silicon Valley Bank (SIVB) CEO Greg Becker released a letter (click here) stating that the bank was looking to raise $2.25 billion. The market didn't take too kindly to SIVB's letter as the stock opened Thursday's trading down -34% from Wednesday's close, and that was only the beginning.
SIVB ultimately fell -60.40% on Thursday alone (click here) as the market seemed to discount the idea that raising $2.25 billion was a pipe dream for SIVB. A run on the bank was here, SIVB attempted to find a buyer, but given the run that was unfolding that was a pipe dream too. SIVB opened down another -60% on Friday before the stock was halted and it never reopened for trading again (click here). In the immortal words of Keyser Soze, "And, like that, he's gone" (click here), SIVB was shut down by regulators on Friday (click here).
We often write that the S&P 500 will trade beyond the limits of imagination, and if we think about one of the reasons why, it could be that future fundamental events will also unfold beyond the limits of imagination. As of Tuesday's close, SIVB was one of the twenty largest financial institutions in the country. By Friday it was gone. The primary reason why is no different than what transpired in the great financial crisis: complete and total misallocation of capital (i.e., making stupid investments!) causing billions of dollars in losses that effectively left the bank insolvent. Here's a great thread on the subject (click here).
The impact to the S&P 500 was interesting to watch as the index actually traded higher to open Thursday's trading. Almost two hours into trading on Thursday, well after SIVB was getting bludgeoned, the S&P 500 was trading near the high of the day above the ~4,000 marker and was green on the session. That made about as much sense as the weather we've had in San Diego thus far in 2023, but shortly thereafter the S&P 500 woke up to the severity of the situation.
The index traded down from Thursday morning's high at 4,017.81 to a low of 3,908.70 before closing the day at 3,918.32, a decline of -1.85% on the day. Friday's trading was wild too, with the S&P 500 up to 3,934.05 a few hours into trading only to then trade down to 3,846.32 before finishing the week at 3,861.59. Friday's decline of -1.45% marked a cumulative two-day decline of -3.27%, the worst two-day stretch since December of 2022. In total, the week recorded as a "bearish outside reversal week", or a trading week with a higher high, lower low, and lower close than the week prior. The index is now down four of the last five weeks and has lost -6.65% over the last five weeks.
Treasury bonds were the beneficiary of the "flight to safety" trade. Bond prices soared across the yield curve, sending interest rates plunging. The yield on a 2-year United States Treasury bond fell from 5.05% at Wednesday's close to 4.60% at Friday's close, 10-year United States Treasury bond yields fell from 3.98% on Wednesday's close to 3.70% on Friday's close, and 30-year yields fell from 3.88% to 3.70%. The iShares 20+ Year Treasury Bond ETF (TLT) gained 3.70% total the last two trading days, the best two-day stretch since December of 2022 too.
So, where are we now? The picture for the S&P 500 has turned ugly.
Anytime the S&P 500 is hit with a one-two punch of this magnitude there's bound to be a few cobwebs as the index attempts to regain its footing. The Volatility Index (VIX) moved higher by 6 full percentage points this week and closed the week at 24.80, so volatility is to be expected going forward.
Further, the fundamental situation for SIVB adds yet another somewhat binary market-moving catalyst into the mix. If SIVB depositors are not bailed out (i.e., they're not provided any assurance that they'll be made whole quickly via either the Fed or a third party), then there are material implications across the entire financial system. At a basic level, confidence in the banking system will deteriorate and anyone and everyone with capital not covered by FDIC insurance will be scrambling, the velocity of money moving from one financial institution to another will likely rival or exceed what we saw in 2008.
Importantly, perception is probably more important than reality at this point.
While SIVB depositors appear to be mostly protected even if no special circumstances arrive, assuming most of the math we've read is correct, that's not the perception at the moment. And we tend to live in "bailout nation" (click here) so some form of a bailout is likely and somewhat sensible in the context of SIVB.
From our view, why should SIVB depositors, most of them being on the commercial side (i.e., small business owners, startups and publicly traded companies), be penalized (some perhaps forced out of business) because of the mismanagement of their funds, especially since they had no say in the ongoing management of their funds? At the bare minimum, FDIC rules pertaining to business accounts needs to be completely revamped, that much is obvious at this point.
We don't have all the answers here, but we all can see the S&P 500 cheering "bailout nation" and jeering any situation in which there's a crisis of confidence and a degree of contagion. It's a case of deja vu back to Bear Stearns (bailout and subsequent market rally) vs. Lehman Brothers (no bailout and a market crash). Importantly, any bailout is not necessarily an all-clear sign over a longer period of time! Much like the market rally following Bear Stearns, which proved temporary, we can't be sure any rally following a bailout will have any staying power.
This is because all of this is unfolding on top of the four-headed monster we've already been discussing ad nauseam: inflation, Fed policy, interest rates, the U.S. Dollar Index. Soft landing or hard landing? The issues with SIVB, presuming a favorable outcome, don't provide any assurance that we'll get favorable outcomes with the four-headed monster, they don't assure us of a soft landing. That fight is still being fought and we're not exactly winning it by a wide margin at the moment.
Further, there is growing momentum that runaway inflation and subsequent Fed policy played, and is playing, a meaningful role in causing stress within the financial sector. Higher short-term interest rates (a derivative of the Fed's fight against inflation by skyrocketing the federal funds rate) influence depositors' decision-making and behavior (i.e., they're now motivated to transfer money out of larger financial institutions in an effort to earn higher interest rates via alternatives like online savings accounts and securities like short-term Treasury bills). This lowers bank deposits.
Collapsing bond prices in 2022 then lower the value of mark-to-market Treasury assets held on the balance sheet of financial institutions, thus lowering the bank's total capitalization.
This is why the issues that plagued SIVB are not in isolation, they're plaguing most everyone in the financial sector.
For example, SPDR S&P Regional Banking ETF (KRE) fell -16.05% this week, its fourth worst weekly decline in its history. First Republic Bank (FRC) fell -33.65% this week too. So, there's a narrative here that the Fed needs to pause, and sooner rather than later, to help the financial sector find reprieve. But what impact does that then have on its fight against inflation? The Fed is meeting on Monday morning and they'll be sure to discuss...
Speaking of inflation, we'll get the Consumer Price Index (CPI) report on Tuesday and the Producer Price Index (PPI) on Wednesday. Inflation data has come in hotter than expected of late, fueling the S&P 500's downside reversal the second half of February as the market began to price in a growing probability of a 0.50% rate hike in March. Whether the Fed raises 0.25% or 0.50% in March now has to at least consider how this decision affects the current turmoil and instability in the financial sector. Who else might be swimming naked?
S&P 500 Primary Trend - Neutral
The S&P 500 is presently down -2.73% thus far in the month of March. Given February's second-half selloff, and now the start here in March, our work continues to label the primary trend as "neutral", or trendless. Trendless market climates are infuriating, the S&P 500 remains stuck.
We believe long-term investors remain best served investing in a moderate to moderately conservative asset allocation, avoiding any big bets and emphasizing "diversification".
While the S&P 500 lacks a primary trend (i.e., stocks are in neutral), another broad asset class is in a primary uptrend, or 'drive", and that's short-term Treasury bills! With the yield on a 1-year Treasury bill closing Friday at 4.90% we now live in a world best defined with the acronym "TARA" (There Are Reasonable Alternatives).
While individual attributes and preferences matter, the majority of investors are best served having a massive overweight toward Treasury bills with an underweight toward stocks. It's the old adage that "it's better to be safe than sorry", and positioning today in an effort to be safe tomorrow is an overweight toward Treasury bills and an underweight toward stocks.
Now, "neutral" trends are indicative of a wide range of forward-looking outcomes, and asset allocations overly concentrated in one asset class are a binary bet on only one future forward-looking outcome! That's the opposite of aligning your portfolio with the primary trend. There are times where the benefits of "diversification" are overemphasized across the community of investment managers, times where the data suggests the probability of recession is as close to zero as possible. Obviously, now is not one of those times.
Speaking of a wide range of forward-looking outcomes, that's 2023 in a nutshell: the whole debate between soft and hard landing!
Since we can't predict soft vs. hard landing with any degree of confidence, we need to own asset classes that are expected to perform well in a soft landing (stocks) and assets that are expected to perform well in a hard landing (Treasury bills and bonds). Individual investor attributes can then influence the percentage one chooses to allocate across these asset classes, but we believe it's a huge mistake to eliminate either of these asset classes.
Happy Sunday!Steve & Rick