Wow, what a month. After a down month in February, the S&P 500 rebounded early in March before dropping hard amidst the bank crisis (see below). Bottoming on March 13, the S&P moved higher to close the month with gains of 3.5%, coming full circle to close higher than the peak earlier in the month. An interesting round trip. The DOW gained 1.4%, NASDAQ gained 6.8%, and bonds gained 3.1%. RSP/equal weight declined 1.7%, mid-caps declined 4.3% and RPV/value shed 7.7%. Clearly the market experienced a sizable shift over the course of a very busy month.
What moved the market
Upon the heels of the hotter than expected February inflation data, Fed Chair Powell, during his Congressional Testimony on March 8th, stated that he was prepared to increase the pace of rate hikes. This statement crushed investors’ hopes of a moderation in rate increases. The market sold off during his testimony, fearing that more rate hikes than what was “priced in” to the market would push the expected Fed “pause” further out into the future.
But the big market driver was the collapse of three banks over the following week. Silvergate Bank (a leader in Crypto banking), Silicon Valley Bank (a leader in venture capital/start up banking), and Savings Bank of NY all failed during the seven days starting March 10th. The following week, stress in the large European bank, Credit Suisse, continued to rattle the stock market and heightened concern of a widespread banking crisis. While each of these bank collapses are probably isolated and likely a result of their unique business focus, it did raise the concern that these events may be the early cracks forming due to the Fed’s aggressive rate hikes over the past year.
The US government quickly contained the contagion by backstopping customers’ uninsured deposits. A classic “run on the bank” at SVB quickly left the bank with insufficient liquid assets to meet depositor withdrawal demands, dampening the trust and confidence that is the foundation of our banking system. Other regional banks experienced an increase in depositor withdrawals, which could easily cause a crisis of confidence across the entire banking system. The swift response from our government re-set confidence, perhaps temporarily, but such a situation does show how important our banking capital structure is on almost every corner of economic activity.
The Regional bank index (KRE) declined almost 25% during that week and has yet to bounce back. Nearly every sector that is more dependent on bank financing and loan issuance declined dramatically. Small companies are inherently more reliant on credit availability and sold off 10%. Materials and energy, two other capital-intensive sectors, sold off hard as well. Companies that are flush with cash, and much less dependent on bank lending held up, leading to a “flight to quality” in mega cap tech. QQQ declined marginally but was then quickly bought by the investor community. The S&P 500 held up relatively well given the significant weighting of mega cap tech. S&P Equal weight (RSP), more indicative of the overall economy, declined twice the rate of the S&P, seemingly ending its yearlong strength relative to the market cap weighted index (SPY).
WHAT A FRAGILE BANKING SYSTEM MEANS FOR THE OVERALL ECONOMY
The health of the banking sector is so important to the economy that such stress and concern about banks have potentially significant knock-on effects. Banks are a key component to economic growth and the economic impact of recent banking stress is highly uncertain.
The government backstop of uninsured deposits is essentially being funded through the FDIC, which in turn is funded from member banks. Thus, banks’ costs will dramatically rise. Furthermore, to maintain its deposit base and stop further bank runs, many banks will be forced to increase the yield on their depository accounts, further impacting their bottom line. With an inverted yield curve (short duration bonds yielding more than long duration bonds), it’s hard to imagine that banks profits will not suffer. Think about it, other than being “in the business” of making loans, when banks must pay more interest on deposits than what they are charging on loans, there is not really a compelling profit incentive to conduct its core activities. These effects are probably deflationary in nature and will likely lead to tighter lending standards and slowing economic activity. Perhaps the current challenges with the banks will effectively do some of the Fed’s work for it. There is a good possibility that reduced loan issuance, tighter economic conditions, and banks limping through the effects of the rate cycle may lead to less economic activity and thus help tame inflation. However, the odds of a recession have increased substantially.
The immediate effect of the banking stress was evident in the bond market as yield volatility spiked on the heels of the bank troubles. Bond yields cratered, with the 10-year treasury crashing to 3.5% from 4% before the banking stress. The 2-year treasury yield declined to 3.8% from 5.05%. These are huge moves for bonds. Lower yields imply tighter future economic conditions and slower growth. The level of rate volatility across the fixed income spectrum makes valuation of stocks near impossible, leading to more speculation (less conviction) in the ownership of stocks and the direction of the overall economy.
The importance of fixed income stability cannot be understated, as rate stability is a large part of anything tied to financials – from real estate to insurance and energy and almost all business operations – credit availability and stability is extremely important. So, when bonds have wild swings, it impacts much more than just banks. Value funds, to which we were overweight leading to this banking stress, inherently have more exposure to financial services, insurance, energy and materials sectors. Equal weight S&P (RSP) has a higher weighting to these sectors as well. Most banks are small and medium sized businesses, thereby causing the small and mid-cap indices to sell off more than the large cap weighted S&P and QQQ’s. Unfortunately, most of our exposure during this drawdown was in the strike zone of what got hit the hardest. But we’ve adjusted (see below).
PORTFOLIO ADJUSTMENTS:
During the turmoil and volatility in March, we effected a substantial overhaul of our allocation. We started the month with approximately 45% of our equity exposure in value (RPV), and 20% of our equity exposure each in S&P equal weight (RSP) and Europe (IEV). By the end of the month, our exposure to equities was 13% value (SPYV), 20% Europe, 35% Large Blend (MOAT and SPLG), and 15% large growth (QQQ).
As surmised in the February client note, there was evidence of RPV losing some of its strength relative to blend and growth. After a 15% gain in January, RPV declined 6% in February, 3% more than the S&P 500. But over the course of January and February, RPV was still outperforming the S&P 500 by 5%. Mid-caps trended in a similar manner to RPV, and on 3/2 our process recommending shifting some RPV exposure to IJH, The S&P midcap index fund. RPV quickly dropped 9% over four days from the initial shock from the bank failures, and we further reduced exposure on the 10th and the 13th. We completely evacuated RPV on 3/16, but unfortunately after giving back all of the gains and then some on that trade. Some proceeds were reinvested in SPYV, a value fund with a lower risk profile.
On 3/17 our process began to lean towards growth, and we initiated a position in QQQ, which we added to on 3/22 and again on 3/30.
We evacuated mid-caps/IJH on 3/20 and 3/22 and re-invested the proceeds into the S&P 500.
On 3/23 we shifted our S&P equal weight/RSP fund to a new constituent, MOAT. MOAT is a large cap blend fund that holds a basket of stocks considered to have a wide moat, or a competitive edge that is not easily replicated. The components of this fund should theoretically weather a storm well, and its pricing movement reflects its current relative strength vs the overall market.
We have maintained our position in Europe/IEV, which has doubled the returns of the S&P 500 YTD.
TWG models are up 3.5% from the mid-March lows but are still down for the month and quarter due to the sharp declines amidst the banking stress. The current positioning is much more balanced, which we believe is prudent given the backdrop and the uncertainty surrounding the financial stresses in the economy. A 15% position in a 4.6% yielding money market fund is being used to cushion volatility and provide a competitive, safe yield.
MODELING ADJUSTMENTS
After the shock this month, we find it necessary and prudent to adjust and broaden our modeling process. Our programmers quickly went to work to develop additional strategies to broaden the combination of models that we had been using for the past several years. These strategies contain between 15-20 models, where before we were running five models total.
The purpose of these strategies is to increase diversification and differentiate the analysis on which the algorithm bases its relative strength recommendations. Now, we have more models per strategy, with each model having a differing re-evaluation schedule, price movement sensitivity levels, and, most importantly, additional constituents to evaluate relative to one another.
We are grateful to have the flexibility to adjust the modeling process as needed, as the speed of change in this current tumultuous environment is highly irregular. When market trends change as quickly as they are, it is imperative that we have the flexibility to adjust to the current environment more quickly.
LOOKING AHEAD
In our opinion, we are now entering the second phase of a prolonged bear market. The S&P is at a similar level to what it was two years ago, with a lot of changes taking place at the sector level. Case in point – last year’s laggards (growth for instance), have rapidly emerged as this year’s winners (QQQ down 34% in 2023 and up 20% so far in 2023). And last year’s winners are this year’s losers (energy, up 52% in 2022 was down over 12% YTD through March 24th).
Last year’s market declines were by and large a function of uncertainty of how high the Fed would have to raise rates and the possible impact on corporate profits. Part of the analysis was how long rates will stay elevated, and whether a soft landing could be engineered. With rates much closer to their expected high point, and inflation having trended down for months now, the market will be subject to the full effects of aggressive increases in rates over the past year. Moving forward we think that the market will be driven more by fundamentals – profit, earnings, valuation – now that the effects of rate increases are becoming fully embedded into the economy. Remember, rising rates take about 12 months to permeate economic activity, so only the earliest rate increases are fully imbedded into the economy. As rate increases have moderated this year, we are still months away for the full tightening cycle to make its way through the economy. The banking crisis was the first ‘tell” of how meaningful the rate increase cycle has been, and the impacts that a rise in rates from 0% to 4.5% in a year can have on a particular corner of the market. We think that there is a high probability that stress will begin to occur in other corners of the economy that will be similarly negatively impacted by the prior rate increases.
In our view, the biggest factor for why the market only declined 25% last year, and rallied so far this year, is due to the surprising strength of the consumer (and by extension, corporations). A strong consumer, even with high rates, could keep the economy humming along and avert a recession. If inflation moderated down to the target 2% range while consumption still holding up, a soft landing was more probable. Thus, the market was hopeful of a soft landing based on fundamentals staying strong even in the face of rate increases.
However, as we’ve written in past notes, the longer rates and inflation stay elevated, the more likely there will be a hard landing, or increase in odds of a recession. While inflation has come down from 9% to 6%, it is still three times higher than the Fed’s target range of 2%, so there is still more work to do, which will take more time. Credit card balances have been growing as the pandemic enhanced consumer savings have begun to dwindle or dry up. Corporate debt prior to 2022 will be maturing over the next years and will have to be re-financed at much higher rates. The money supply (M2), that spiked post covid due to stimulus measures, has cratered over the past six months. And, what had been a very tight labor market is starting to show signs of loosening, as more and more companies continue to announce layoffs as a means to increase operational efficiencies to counteract the impacts of higher costs (interest rates, labor, etc).
Thus, we feel that a more challenging economic environment lies ahead, which we will need to navigate with even more care and flexibility than in the past.
If you consider how long rates were near zero, the significant “pull forward” effect from the pandemic stimulus that pushed the market to extreme valuation levels, a cooling off period to “reset” the imbalances created by a decade of low rates, the world shutting down and the global stimulus measures taken to prop up a sedated economy — it will likely take more than one year to unwind.
We remain confident that better days are closer ahead than they were last year, and after inflation recedes to a healthier level, rates will start to come back down as well. Lower rates should only improve the bottom line of personal and corporate balance sheets, and we will all emerge leaner and more efficient. Our process is designed to preserve capital during sustained market declines, so that if another substantial market decline like we lived through in 2000 and 2008 unfolds, our ability to objectively reduce risk will help preserve more of what you have invested. This is why we reduce risk and move to cash when the pricing action is decisively down. When the economic contraction concludes, you should have more capital than you otherwise would had you simply plugged your nose and ride out the volatility should a major market decline occur. When the tides change and the economy begins to expand again, your capital will be put to work in the most productive areas of the market. Our process has a bias to stay invested, so with a sustained uptrend, we’ll seek out the areas of relative strength. Over a full market cycle, we do anticipate outperformance, notwithstanding periods of underperformance throughout the cycle.
We are more prepared than even to navigate the ongoing challenges that the current environment provides and are committed to objectively manage whatever the future presents.
We wish you well.
