March is known for excitement around college basketball with the kickoff (or jump ball in basketball parlance) of the annual NCAA Basketball Tournaments. To that end, we have never seen a men’s NCAA Tournament as exciting as this one with number 16 (#1 Purdue - 58 vs # 16 Fairleigh Dickinson - 63) and 15 seeds (#2 Arizona - 55 - #15 Princeton - 59) advancing through the first round! In fact, Purdue were 10-1 odds before Fairleigh Dickinson rained on their parade. Fairleigh Dickinson advanced to the Final Four, as of writing this, and the highest ranked team remaining is #4 UCONN (my alma mater). The women bracket still has two #1 (S. Carolina & Virginia Tech) teams remaining and they will go up against #2 (Iowa) and #3 seeds (LSU), respectively.
The stock market has seen its own share of madness, historically, in the month of March. The last two bear markets ended on March 9, 2009, and March 23, 2020. However, March 2023 will not mark a new bottom in the market. We continue to be in bear market territory which began January 3, 2022, and saw its current bottom on October 12, 2022, at 3,577, down 25% from the January 2022 all-time high. Only time will offer confirmation of whether this is the bottom. The S&P 500 will need to rise by at least 20% to 4,292, off the October bottom, to mark a new bull market. The S&P 500 closed the quarter at 4,109, which means we still have another 4%+ to go to reach bull market territory.
2023 has offered up a different sort of March madness with the banking issues that rattled the markets mid-month. It has not been a month for the faint of heart as we saw the 2nd (Silicon Valley Bank – SIVB) and 3rd (Signature Bank – SBNY) largest bank failures of all time. Being the creatures of habit that we are, we tend to invoke recency bias when we hear about banking failures. The natural tendency is to recall the last time these events happened and try to draw similarities or comparisons to what we experienced during the Great Recession in 2008. At present, the only similarities that seem to exist are that the events of 2008 and 2023 both involved banks, and that is the extent of the similarities. While there will likely be a great deal more learned as time goes on, what we presently know is that SIVB had mismanaged their portfolio and a run on deposits revealed the issue. Subsequently, SBNY was perceived to have a very similar deposit base by the FDIC and the end result was that both were seized by the FDIC. Banking failures are actually more common than one would think. In the last 10 years there have been 514 failures, amounting to $342.8B in assets.
To shed a little light on what actually happened with the Silicon Valley Bank, it is important to first break down the general options that banks have when new deposits are coming in the door. In very general terms, there are three strategies that a bank executes with new deposits coming in the door; it may place them in short-term obligations to meet any customer withdrawals, it may invest in longer-term obligations for the future, or it can lend out those funds out. Silicon Valley Bank experienced an unprecedented inflow of deposits. In 2019, they had just $49B of deposits, in 2020 that jumped to $102B and in 2021 that jumped again to $189.2B. They simply could not lend these funds as fast as they were coming in. That essentially left two other choices: short or long-term investments. One would assume that since they had a record number of inflows that they could naturally satisfy short-term withdraw requests and they ultimately allocated a large portion of these incoming deposits to long-term assets. By design, these long-term assets were meant to be held to maturity. The long-term investments the bank made with these assets were in US Treasuries and asset-backed mortgages, both of which are considered extremely safe investments. However, the investment strategy was to hold these investments until maturity and not be obligated to sell them in the midst of their term.
This is where the aggressive interest rate increases by the FOMC becomes one of the ingredients that led to the bank’s demise. As interest rates go up, the value of a fixed income security goes down. If you plan to hold the fixed income security until maturity, you will be paid the stated interest rate during the course of the term and will receive the par value at maturity. To provide an example, let’s say you purchase a US Treasury note for at par value for $10,000 at 3% annual interest and the term is 2-years. This means that you will earn 3% on $10,000 or $300, per year and at the end of the two-year period, you will receive the par value, or $10,000, back. US Treasury notes are backed by the full faith of the US Government. They are one of the most secure investments available as the US Government is able to leverage their ability to tax its citizens to pay the interest and return the par value at maturity. SIVB’s issue was not with the type of investment they selected, it was that the investment strategy was designed for long-term and not enough was allocated to the short-term. This graphic illustrates what happens when interest rates rise and what it does to the market value (not par value) on a fixed income security, better known as interest rate risk:
Source: https://www.fidelity.me/beginners/bond-investing-made-simple/how-interest-rates-affect-bonds
If interest rates go up by 1%, in this example, the market price of the bond must decrease in order to entice someone to purchase a 3% bond when the going rate is 4%. This is what led to SIVB’s liquidity issues. When all short-term funds were exhausted, they then had to turn to selling long-term investments, before they matured, and were stuck selling a security that would return $10,000 at maturity for $7,500 market value (using the numbers in the above graphic for purposes of my example). The longer the time until maturity, the more sensitive to the investment will be to interest rate risk.
Everything began to unravel for the bank when they had to start selling assets for less than what they were worth. To quote Warren Buffet, “It’s only when the tide goes out that you learn who’s been swimming naked.” Rumors began to spread that SIVB was selling assets, which only caused more depositors to panic and it snowballed to the point where the FDIC, Fed and Treasury Department all got involved and put SIVB into FDIC receivership. But this also illuminated the issue that the bulk of the deposits were above the $250,000 threshold.
Source: https://www.wsj.com/articles/silicon-valley-banks-meltdown-visualized-3da2263b
SIVB’s deposit base was not the normal profile of most banks that have a large retail base, instead they dealt with a niche Silicon Valley market of start-ups, early-stage technology and science/healthcare, and technology. These were companies that were highly reliant on venture capital and corporate funding. It is this same tightly connected community that began to advise companies to pull their deposits, again fanning the flames.
The second bank that failed, Signature Bank, also had a large crypto and tech start-up depositor profile. They too saw a run on deposits, but nowhere near the same magnitude as SIVB. Nonetheless, regulators seized them on Sunday March 12th on fears of contagion. There is some noteworthy irony in all of this. Post-Great Recession, US Representative Barney Frank and Senator Chris Dodd penned the “Dodd-Frank Wall Street Reform and Consumer Protection Act”, which was enacted into law in 2010. Dodd-Frank was meant to overhaul financial regulation and to improve consumer protections and financial stability. Ironically, Rep Frank was on the Board of Directors at Signature Bank at the time of its seizure. Note this is not meant as an attack, criticism, or to suggest any wrongdoing towards Rep. Frank, instead it is merely meant to point out the irony in the big picture of bank regulation and failures.
Today we still feel the aftershocks over the collapse of these two banks and many are waiting for the next shoe to drop. To date, these issues seem to be relegated to only SIVB and SBNY, in the US. The Federal Reserve Board (Fed) created a new lending window for eligible depository institutions called the Bank Term Funding Program (BTFP). This window essentially allows banks to take longer-term assets, that are currently trading below par value, trade them in to the Fed and receive par value in exchange for a one-year loan with the Fed. To use my example above, it would be as if the bank took the note worth $7,500, exchanged it at the BTFP window, and received $10,000 in exchange. The bank and the Fed would then agree on loan terms so as to repay the $10,000 collateralized loan, over a one-year period. The BTFP seems to have brought some much needed stability to the banking system. Banks seem to be using this program and their traditional Discount Window:
Yields in the bond market dropped precipitously on the news of the bank failures. Some argue that the failures themselves are equivalent to the FOMC hiking rates, which may mean that the FOMC is done raising rates, or be pretty close to it. In the chart below, you can see the moment the failures were made public by the large drop in the 2-year yield, from 5.05% on 3/8 to 4.03% on 3/13. The 10-year yield was also lower, but not by the same magnitude (3.98% vs 3.55%). Nonetheless, the rate on a 2-year note still exceeds the rate on a 10-year. The proper term for this is yield curve inversion. What it illustrates is that interest rates will be high in the short term and the FOMC will need to lower them in the long term.
Despite the shocks that rippled through the markets this month, we saw the S&P 500 close up 7.50% for the first quarter, with 3.51% of that coming in the month of March. The NASDAQ was up a whopping 17.05% for the quarter with the Dow 30 only up 0.93% on the quarter. These results illustrate that investors seem to be turning their attention back to growth oriented securities, and fading value oriented. To that end, the stocks in the S&P 500 had some of the largest market capitalization declines in 2022 and were some of the best performers this year.
Source: https://www.marketwatch.com/story/these-20-stocks-were-the-biggest-losers-of-2022-11672360725 & www.Google.com/finance
In closing, it is important to remember that investing is a long game. History has shown that patience pays off, as is evidenced in the graphic below. The following chart illustrates rolling returns over 1, 5, 10 and 20-year periods. Rolling returns are where you overlay a 10-year period, as an example, over any sliding period from 1950 – 2022. It is not simply looking at calendar year returns, but any 10-year period over the referenced time. In looking at the two bookends of this chart, over a 1-year period stock returns produced returns ranging from -37% to +52.6%, while bonds ranged from -9.4% to +29.1%. On the other end, at 20-years you have returns for stocks ranging from +5.6% to 17.9% and bonds ranging from +2.4% to +10.0%. The summary here is that the longer your view, the less distribution in your potential returns and the higher probability of positive returns:
Source: Alger
If you have any questions or would like to discuss your personal circumstances, please do not hesitate to reach out to me.
Feel free to schedule a quick 15-minute coffee chat with me.
Rob Leiphart, CFP®
203-220-6474
rleiphart@rbcapitalmanagement.com