Another March and another month of madness to try and process. Normally we welcome March as it brings spring flowers, warmer weather and one of the best tournaments in all of sports, NCAA’s March Madness. For the uninitiated, March Madness is a basketball tournament full of upsets, David and Goliath stories and amazing individual and team accomplishments. One of our favorite parts of March Madness is the upsets by the underdogs like a 15th or 16th seed beating a number one seed. Unfortunately, this year the madness has spread like a contagion into the financial markets as the number 16 sized bank, Silicon Valley Bank (SVB), decided to upset the entire marketplace. Keep in mind, though, we think the marketplace, just like the NCAA tournament bracket, will trend towards normalcy. In the storied history of NCAA basketball tournaments more number one seeds have won tournaments than number 16 seeds. So, while drama has ensued from SVB we don’t think the market faces any systematic risk it can’t handle. In other words, the games will play on, and you have to be in it, to win it.
Convenient sports analogies aside, SVB is an interesting experiment in what happens when you raise interest rates faster than any time in modern history after flooding the market with more money than it has ever seen. It reminds us of the story referenced in the book “Playing God with Yellowstone” where the government creates problems, tries to fix the problems they created and then gives birth to a new set of problems. They then argue they couldn’t predict these problems, but we should trust they can fix the issues. It is enough to drive one mad. Specifically, during a pandemic SVB doubled in size and fuel was added to the fire since the bank specializes in illiquid investments such as private equity and venture capital which doesn’t work well in a low interest rate environment. Therefore, you should probably expect something to break when a bank whose depositor base was over 90% uninsured runs into liquidity concerns (as an aside the majority of smaller, regional banks have around 50% uninsured deposits and are more diverse in their investor base). Add to this the fact that the SVB Chief Risk Officer resigned, and they didn’t hedge their longer-term Treasury holdings in a rising rate environment, and you see where the lethal combination occurs. Of course, these tech savvy depositors were certainly smart enough to know how to pull their money from one bank to another with a push of a button and that is exactly what they did. The “run on the bank” became one of the fastest occurrences we have ever seen. All of this is to say, SVB was a perfect storm for a set of bad actors: The Federal Reserve for raising rates too fast (after telling us inflation was transitory for too long) and a fast-growing bank who didn’t manage its business very well.
Of course, around the same time, two crypto-currency centric banks were also failing, Silvergate and Signature Bank. We think these were similar to Silicon Valley Bank in that they were niche banks with a large set of uninsured depositors. So, the run on these banks also seems somewhat business model driven as crypto-businesses had been squeezed over the past year and the depositor base was again not very diverse. Timing was not fortuitous either, as one ripple in a system can typically be managed but three or more can cause problems. Then after a week passed, we had the regional bank contagion spill into a European Bank, Credit Suisse, which had been in trouble for a while. In our opinion, this is another atypical situation as Credit Suisse had been under fire for litigation issues and lack of institutional control for years. In fact, if someone had asked us to pick a bank to fail or merge with another (UBS in this scenario), Credit Suisse would have been at the top of that list.
Madness aside, capitalism and the fractional banking system, from our vantage point, is working. Poorly run banks are disappearing and the government is providing a backstop to keep the fractional banking system from destabilizing. That being said, a banking system that allows smaller, regional banks to serve niche markets and smaller communities is very important. If the United States were comprised of five or six national banks (like some countries), the flow of cash to new ideas would not move quickly enough, in our mind. So, we are rooting for well-run smaller banks to continue to thrive and not be painted with a broad brush because of a few others. And yes, we realize we are a little biased being an affiliate of Synovus bank with a diverse set of depositors and strong institutional control. Of course, we also think the banks left standing will be well positioned for the future as one of the tenets of capitalism is that failure leaves us with the strongest survivors. In fact, many strong businesses entrench their position even more during a market correction, while their weaker counterparts lose ground. A side effect of rising rates and tighter lending conditions is that weaker, more speculative businesses, fail at a faster rate. Another corollary is that inflation typically slows down, so maybe the Fed is on its way to hitting its target of price stability and employment. We remain a little skeptical here as the Federal Reserve has a history of being more reactive than we would like, and we are mindful of unintended consequences.
What does all this mean to our clients? How do we make sense of all the madness? Well, macro considerations like inflation, recessions and interest rates are fun to talk about and we are aware of them, but fundamentals and incremental moves are what matter as they are what we control the best. Historically, roughly two-thirds of the time the market goes up, so we want to be in the stock market so we can participate in the upside. Recessions occur and are part of a normal market cycle. Balance sheet recessions like the one we had in 2008/2009 are the scariest and we don’t think we are in situation like that now. Leverage levels and balance sheets are much better than they were then so our feeling has been that if we have a recession, it would be shallow, and trying to time a shallow recession with dramatic moves proves exceedingly difficult. In fact, one could argue the market has already corrected to recessionary levels in small cap, semiconductors, housing, regional banks and technology companies. Thus, one could make the case for legging into these areas in portfolios that were conservatively positioned last year and didn’t lose as much as the benchmarks. Finally, we kept fixed income short in duration last year and it worked very well for our portfolios. We are okay lengthening duration in portfolios right now but find our flexible mandate fixed income managers are already moving in that direction for us without being permanently tied to an aggregate bond index with a duration and interest rate risk at higher levels than we want. In fact, we have been finding fixed income names at attractive levels for those clients seeking individual bonds. It reminds of us of the old days (pre-2008) when we used to purchase a significant amount of individual bonds. We are happy to do that again if yields become attractive enough as it lowers expenses across all accounts.
Finally, we like to finish our quarterly letter by tying it back to our theme in hopes we haven’t packed it so full of dry, financial information that you have drifted into slumber. We cannot deliver a quarterly missive as titillating as March Madness. The ups and downs of the tournament are exciting, but rest assured we don’t want that much movement in your portfolio. We want our investing style to bore you to wealth. Our new reporting software took longer than expected last quarter, but the reporting vendor has promised your letters will go out quicker than last quarter. On that note, we hope the letter makes it out to you before you forget all the excitement from the tournament brackets but after the drama from the banking sector has subsided. Fingers crossed for both of these.
P.S. – We don’t proclaim to have any knowledge on basketball winners/losers so please don’t call for any advice on your brackets as we will be leading you astray. We love the tournament but don’t have enough time to become experts on basketball teams and players. Now college football is a different matter as we will be more than happy to give you our opinion… speaking of Madness!
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