Monthly Archives: March 2023

After my last email on Silicon Valley Bank (SVB), I received several questions inquiring more specifically why SVB failed (and why are the other banks such a concern).

Before addressing that, I want to emphasize that unlike some other broker-dealers, LPL does not own a bank.  Any banking services offered through LPL are offered through contractual arrangements with outside banks.  Therefore, LPL does not have the same risk exposure that other banks and some broker-dealers are potentially facing.

The primary reason why SVB failed and why other banks are in the news is an old-fashioned, simple reason:  they borrowed short and loaned long.  This means they took depositor’s money (borrowed short) and bought long-term U.S. Government bonds (loaned money to the government…bonds are loans).

Unlike 2008, this situation did not involve toxic mortgage debt that was opaque at best.  It was simply a poor strategy of tying up capital in long-term assets when depositors could demand their money back at any time.

To be sure, all banks do this to some degree:  they take in depositor money and lend it out with the expectation of being repaid over time.  But based on what has been reported, this situation was extreme.  The bank simply took on too much risk.  The modern-day bank run can now take place online with a few clicks of the keyboard.  Throw in social media where news travels fast and the takedown of SVB was quick.

As for the bonds owned by SVB, investors generally receive a higher yield (interest payment) on a long-term bond, but these bonds are more sensitive to interest rates.  There is an inverse relationship between interest rates and bond prices: if rates go up, bond prices go down (all other things being equal).  Longer-term bonds (i.e., 10-30 years) are hit hardest.  Using simple bond math, the worst of the long-term bonds in SVB’s portfolio probably went down 25% to 45%.

Now, if SVB could have held the bonds to maturity (10-30 years), then the bond would be redeemed by the U.S. Treasury at its “par value” – no principal loss to the bank.  Or, if interest rates were to drop substantially, then the drop in rates could erase the loss.  But when depositors show up demanding cash, banks can’t wait.  SVB had to sell bonds at a loss to pay their depositors, and it became quickly and painfully obvious that they were in trouble.

Another problem for SVB was their niche customer base, which was early-stage venture capital customers.  Apparently, a flood of cash came into SVB during the 2020-2021 tech boom.  It was a perfect storm for SVB.

For now, it appears that the banking issues are contained.  The authorities have set up a couple of credit lines for other banks who might be facing trouble to borrow funds and pledge their securities as collateral.  Expect more headlines, but also expect a vigorous response should further trouble arise.

The S&P 500 peaked almost 15 months ago and still remains nearly 20% below that peak. Moreover, the bear market in the more aggressive growth stocks began 25 months ago in February of 2021. Given those facts, you’re forgiven if you’re starting to feel some “volatility fatigue”.

And now the 16th largest bank in the country failed.

Where do things go from here? The honest answer is that it’s unknowable where they go in the short-term. But it’s good to see the authorities moving quickly to clean up the bank failure (though reasonable minds might disagree on the rather extraordinary move to guarantee all deposits. I am writing this on Sunday evening, March 12th.)

As we all know, the Federal Reserve has aggressively hiked the federal funds rate in a short period of time to fight an inflation that was caused by fiscal “stimulus” and loose Fed monetary policy. By moving aggressively, my fear has always been that they were going to “break something” significant which leads to an old-fashioned financial panic whereby trust evaporates and liquidity vanishes. Things change, but human nature doesn’t. While we are a long way from a financial panic, it’s worth paying attention to this bank failure.

For those who read these emails, you know that my message is one of relentless, sincere, and passionate optimism on our investment markets. I remain committed to that message as the only sane and responsible way to interpret our system. The modern capitalist system offers individual investors a tremendous opportunity to build large amounts of wealth if they simply play by some basic rules. Over a lifetime, work hard, save, invest in stocks for long-term goals, and don’t let fear infect your investment decisions. That’s the basic formula.

While I remain in the optimist camp, I have an adult memory that tells me additional caution is warranted going forward. Consequently, your volatility fatigue may worsen before it gets better. Prepare yourself. As the cliché goes, it’s darkest before the dawn.

It’s natural to feel intense emotions, but we cannot – we must not – let fear cause us to make mistakes by selling near market bottoms. Fear will lie to you: it’s different this time, don’t be dumb, protect yourself, sell now and buy later when it’s lower, the “smart money” is selling…and on and on Fear will lie to you.

These are the times when investors are tempted to commit large, life-altering, irrevocable mistakes. That is reason #1 why you’ve hired me.

Remember, we’ve done the proper planning to insulate us from short-term volatility by building cash and fixed income (bonds) into your asset mix. In fact, we routinely build in seven years of protection from stock price declines…seven years! We can weather this storm.

Markets will do what markets do, and we must have faith that the recovery will come sooner or later. In the meantime, the relentlessly efficient machine called Mr. Capitalism has now been summoned. As he always does, he must begin eliminating weak market participants. Eventually, cheap money always leads to excessive risk-taking and funds dumb ideas, and they must go. We’re hearing that the Silicon Valley Bank management took excessive risk and made dumb decisions, so they must go.[1] Others will surely follow.

Reasons for Optimism

The only definitive signal firmly indicating recession is the “inverted” yield curve (short-term interest rates are higher than long-term rates), and that’s not always predictive. In contrast, the money supply has leveled out and even contracted some in the last year – this will continue to reduce inflationary pressures. For now, credit spreads remain narrow[2]- and credit spreads are an outstanding indicator of recessions. The “stress index” put out by the Federal Reserve remains low.[3] Corporate profits, while showing some weakness, are mostly hanging in there, and estimates for the back half of this year into next look encouraging. And the January data generally surprised to the upside. The recession might be coming, but these data points don’t suggest it. And even if the recession eventually arrives, corporations and the consumer have had plenty of time to prepare.

The one good thing that will most likely come out of the bank failure – and this should be supportive of stock prices – is a Fed that slows down the monetary medicine and takes a more patient approach. I understand why they moved aggressively – they had no choice. But monetary policy takes a good 12 to 18 months to work its way into the system. The first interest rate hike in this cycle was March 17, 2022, and it was only .25% – so we’re just now tip toeing into 12 months. We probably have not seen the last of headline failures like Silicon Valley Bank.

Even if we are heading into a recession, please keep in mind that stock prices typically bottom well in advance of the economy hitting bottom. The consensus view seems to be that stock prices bottomed in October. Let’s hope so, but let’s acknowledge that our patience and volatility fatigue could be further tested, especially if we hit new lows.

Is the Long-Term Bull Market Still in Place?

For a market that has digested a tremendous amount of bad news, it certainly feels like stocks want to rally on minimal good news. I’ve been surprised at how little it has taken to spark markets to the upside at times. Here is my thought: I certainly cannot prove this to anyone, but the underlying market psychology seems to be one of optimism rather than pessimism. Even the bond market is pricing inflation at only 2.34% over the next five years.[4]

This is NOT a market forecast of any sort – but I wonder if we remain somewhere in the middle of a long-term “secular” bull market that has many more years to run. That could mean that we are currently in a shorter-term “cyclical” bear market. These secular, long-term markets play out over many years, usually decades, and are thought to be rooted in psychology. For a discussion on this, please see my blog post in 2021 or more recent articles here.[5]

Conclusion

For those of you who are still working and saving a portion of your income, revel in the glory of purchasing stock at lower prices. For those who have stopped working, revel in the glory of reinvesting your dividends at lower prices. And for those of you living off dividend income, the current environment is the primary reason why we implemented that strategy.

In closing, it’s worth recalling a Warren Buffet quote: “The stock market is a device for transferring money from the impatient to the patient.”

As always, stay patient, stay disciplined, and stay invested. Please do not hesitate to reach out if you would like to talk through any concerns, big or small. With sincere and deep gratitude, it is a continuing pleasure to serve you.