March 24, 2023
By Steve Blumenthal
“Swing your swing. Not some idea of a swing. Not a swing you saw on TV. Not that swing you wish you had. No, swing your swing. Capable of greatness. Prized only by you. Perfect in its imperfection. Swing your swing. I know, I did.”
– Arnold Palmer
The Economist headlined the cover of one of their magazine issues last spring with the title “The Fed That Failed: How inflation humbled America’s central bank” and a sketch of Ben Franklin with his hand over his face. Fitting, I guess. No white flag. No surrender—ever. The inflation fight rages on.
I made an error in last week’s OMR post when I wrote about Silicon Valley Bank (SVB) and banks in general, which I want to apologize for. I wrote, “Banks make money by paying you X% on your deposit and loaning out the balance with an approximate 10-to-1 leverage. To get a sense of what that looks like, think about it this way: for approximately every dollar on deposit, they are allowed to lend out $10.”
In response, reader Bruce N. sent me the following note:
“Steve, I typically find OMR highly informative and you, highly knowledgeable, but [this]excerpt from yesterday’s OMR is absolutely wrong. By extension, the math that follows the excerpt is wrong, and your assertion about how banks operate undermines your otherwise thoughtful observations and understanding about what happened to SVB, and banks in general.
“Actually, banks leverage their capital 10X, not customers’ deposits. Most banks’ net loan-to-deposit ratios do not exceed 100%, or 1-to-1 leverage. In fact, SVB’s net loan-to-deposit ratio was only 40%, or 0.40-to-1 leverage, and its investment-to-deposit ratio was about 67% or 0.67 to 1. Neither of these ratios represents anything remotely close to the 10X deposit leverage you cited. The core accounting equation of [Assets = Liabilities + Equity] also informs that the deposit leverage you described isn’t possible unless said bank had an exceptionally high level of equity to support the leveraged assets, and that just isn’t how banks work.
“SVB was illiquid and failed due to an unduly risky and over-weighted (not over-leveraged in the classic sense) position in long-duration investments relative to their short-duration deposits. Management’s inattention [to] (or willful ignorance of) interest rate risk and liquidity stress testing cratered them. SVB’s issue wasn’t balance sheet leverage, and their deposits weren’t over-leveraged in the manner you described.
“So, to the extent SVB ‘over-leveraged’ their interest rate risk, you owe your readers a more factual and clearer explanation of the failure and your use of the term ‘over-leverage’ than your example. SVB clearly blew it, just not in the way you described it.”
Thank you, Bruce, for your thoughtful response and correction—much appreciated. And thank you (kind reader) for hearing me out. Please keep the comments and questions coming. I do read them all. If you’ll bear with me, I’d like to delve into the SVB case a bit further.
A Run on the Bank
In simple terms, here’s what happened: SVB bought billions of dollars of bonds over the past couple of years using customers’ deposits, just as a typical bank normally would. These investments are generally safe but have longer durations. Over the last few months, after we saw the largest and fastest interest rate increase since the early 1980s, the value of those longer-duration investments fell. Usually, that’s not an issue because banks can hold onto those for a long time—unless they must sell them in an emergency.
It became an emergency when SVB customers started withdrawing their deposits. the first withdrawals weren’t a big issue, but as they kept coming, the bank was forced to sell its assets at a loss to meet customer requests. SVB was brought down by one of the oldest issues in banking: a run on the bank. Bank regulators then seized the bank to protect the assets and remaining depositors.
Systematic Risk Exception
Fed Chairman Jerome Powell sought to calm investors in his press conference on Wednesday following the Fed’s decision to increase rates another 25 bps, bringing the federal funds rate up to 5%. I’m not sure it was so calming…
- Responding to a question from Bloomberg’s Mike McKee, Chairman Powell said that, in all likelihood, FOMC participants “don’t see rate cuts this year.”
- That any tightening in credit conditions will be welcomed—serving as a “substitute for rate hikes.”
- “No one should doubt, we will do enough to bring inflation back down to 2%.”
In testimony before congress that same day, Treasury Secretary Janet Yellen said:
- While the Systematic Risk Exception determination will be done on a case-by-case basis, they are “likely to invoke it.”
- She defined “systemic” as simply “the risk of a contagious bank run”—with no qualifiers as to size, probability, etc.
- She also explicitly dismissed a “two-tier system” (large banks vs. all other banks) and noted that the failure of even “a community bank could lead to the same outcome” as, for example, Silicon Valley Bank. (Hat tip to Renè Javier Aninao at CORBU.)
Tough talk from the FMOC. Soft talk from the Treasury.
Here’s what’s required to get that Systematic Risk Exemption: Treasury Secretary Yellen must first make a determination on a bank, then consult the President of the United States, then gain a 2/3 approval of the boards of the FDIC and Federal Reserve. Likely? Yes…
This is not a guarantee to the entire banking system. Determination is made on a bank-by-bank basis, and to qualify, a bank must be under FDIC receivership.
Finally, regulators can encourage regional banks to use the Fed’s Discount Window, which is the main direct-lending instrument provided by the Fed to support stability and liquidity in the US banking system. It enables the central bank to lend banks money for up to 90 days, and it’s particularly popular in moments of market stress when obtaining funds from elsewhere is difficult.
Last week, banks borrowed $152.85 billion through the Discount Window—up from $4.58 billion the week before. The previous record was $111 billion, a mark reached during the 2008 financial crisis. What a week!
The banking system remains fragile. JP Morgan said $1.1 trillion has left the most vulnerable banks. The winners? Primarily larger banks, short-term Treasury bills, and money-market funds.
A good friend runs one of the largest specialty brokerage businesses that solely serves credit unions. I shot him a note asking how the credit unions are doing. He responded, “All I know is that EVERY ONE of my clients has had to raise rates +100 bps to keep their deposits, and [all] ARE cutting costs.”
Notable, too, is that the small- to mid-size banks have most of the commercial real estate exposure. I’m not sure what your part of the world looks like, but my office complex is, at best, 20% full on the week’s busiest day (typically Wednesdays). The Vanguard corporate campus is just a mile away. I am not seeing many cars there either.
What does all of this do to bank profit margins? Bank lending standards? Looser? No. Tighter? Yes. Higher borrowing rates? Likely. This will trickle through the economy.
The Fed is signaling that they see a decline in real GDP for the balance of this year and that inflation will remain high. Due to the failures of SVB, Signature Bank, First Republic Bank, and Credit Suisse, there will be tighter bank-lending conditions, which increases the risk of recession—a risk that was already high prior to last week. Recession, slow growth, and inflation (or stagflation) continue to present downside risks to cap-weighted equity indices and many individual companies in general.
Last week, I shared Ray Dalio’s response to a question about SVB. It bears repeating:
“I think that it is a very classic event in the very classic bubble-bursting part of the short-term debt cycle (which lasts about seven years, give or take about three) in which the tight money to curtail credit growth and inflation leads to a self-reinforcing debt-credit contraction that takes place via a domino-falling-like contagion process that continues until central banks create easy money that negates the debt-credit contraction, thus producing more new credit and debt, which creates the seeds for the next big debt problem until these short-term cycles build up the debt assets and liabilities to the point that they are unsustainable and the whole thing collapses in a debt restructuring and debt monetization (which typically happens about once every 75 years, give or take about 25 years).
“While in different cycles, the sectors that are in bubbles are different (i.e., in 2008 it was heavily in residential real estate and now it’s in negative-cash-flow venture and private equity companies as well as commercial real estate companies that can’t take the hit of higher interest rates and tighter money), the self-reinforcing contraction dynamic is the same. Based on my understanding of this dynamic and what is now happening (which line up), this bank failure is a ‘canary in the coal mine’ early-sign dynamic that will have knock-on effects in the venture world and well beyond it.
His conclusion? “Please understand that I’m not sure of anything. That’s why I believe the key to good investing lies in achieving balance of uncorrelated good return streams so that one’s portfolio has little or no bias to go up and down as conditions get better and worse. As I have repeatedly stated, this risk reduction can be done without reducing expected returns. So that’s what I think and what I recommend doing.” (Bold emphasis mine)
This is a special point in time. I worry about most individual investors allocated to overvalued equities and lower-yielding bond funds. Each year, we research hundreds of strategies, hedge fund managers, specialty lending funds, real estate investments, etc., for our clients’ and our own wealth management. We look for specialty niche businesses structured in a simple way that allows investors to gain access—an endowment-like investment approach. Today, I was on a call with a tax lean fund we just added to our platform. It’s a lot of work for the operators, but a nine percent approximate yield with a stable net asset value. The homeowner failed to pay his local real estate tax, so a lean was placed on the house. The township doesn’t want to be in the collectibles business, so they sell the tax lean to the fund at a discount. The tax lean sits senior to all other creditors, even the mortgage provider. This is not a recommendation. I’m simply saying there are ways to invest beyond the traditional 60% stock and 40% bond allocation model. If you like up-and-down volatility with low single-digit annualized returns over the next ten years. Have at it. I could be wrong, but side by side, I don’t like the 60/40 at today’s starting conditions. Regulations require you to be accredited ($1 million net worth or more) to qualify for certain investments. You can learn more at www.cmgprivatewealth.com or email me at blumenthal@cmgwealth.com.
Grab a coffee and find your favorite chair. With permission from Ned Davis Research, I’m sharing one of my favorite equity market indicators with you: volume supply (a smoothed average of the total volume of declining stocks) vs. volume demand (a smoothed average of the total volume of rising stocks). Think of it like this: With more buyers than sellers, the price goes up; with more sellers than buyers, the price goes down. I look at the volume supply vs. demand ratio and other technical indicators daily, and the collective weight of technical evidence continues to suggest caution. You’ll find the full dashboard of indicators in the Trade Signals section (link below).
A short read this week. Hope you find it helfpful.
Each week’s OMR is broken into sections. Feel free to read them one at a time or all in one sitting. Here are this week’s sections:
- Volume Supply vs. Volume Demand – More Sellers than Buyers
- Random Tweets
- Trade Signals: Powell and Yellen – The Fed that Failed
- Personal Note: The Korn Ferry Tour – Club Car Championship Pro/Am
(Reminder: This is not a recommendation to buy or sell any security. My views may change at any time. The information is for discussion purposes only.)
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Volume Supply vs. Volume Demand – More Sellers than Buyers
Focus on the data boxes in the lower section (% Gain / Annum is the same as annualized gain).
- When volume demand is stronger than volume supply, the market has historically performed best.
- The market has historically underperformed when volume supply is stronger than volume demand.
- The middle section plots each: Orange is volume demand; black is volume supply.
- When the black line is higher, there is more selling volume than buying volume, which signals a switch in the game plan to more defense than offense.
Source: Ned Davis Research
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Random Tweets
Yellen in June 2017 – Another financial crisis not likely ‘in our lifetime.’ You just can’t make this stuff up. Yikes!
I’m going to spend some time getting my arms around commercial real estate exposure – especially if most of it sits on the books at small banks. I’m not sure which of the next two charts is correct. The big problem I see is in the commercial office space market.
I don’t see a big risk in Multi-family housing due to the bullish demand-to-supply mismatch. Farmland is also favorable, in my view. I wonder where the office space debt is sitting. I’ll do some digging and get back to you…
More Random Tweets next week. Follow me @SBlumenthalCMG.
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Trade Signals: Powell and Yellen – The Fed that Failed
“The trifecta of trouble? Powell acknowledges credit crunch ahead, says inflation and price stability are still big focus and that they don’t foresee cutting rates this year in response to the consequences of the former and because of the latter.”
Peter Boockvar
The intermediate-term trend for the U.S., International developed, and emerging markets remains bearish. The S&P 500 daily MACD signal turned bullish yesterday. Investor sentiment remains extremely pessimistic. Seeing the market move higher into April would not be a surprise. Risk remains high. However, the intermediate trend is clearly bearish.
The fundamental backdrop remains challenging. We sit atop one of the largest, if not the largest, investment bubbles in the history of markets. Inflated by ultra-aggressive Fed interest policy, bond buying programs (QE), and trillions in legislative stimulus.
Inflation is the result, and the Fed is fighting it with the fastest rate increase in the shortest period of time in 40 years. The banking crisis is the first to appear. Expect tighter lending standards, smaller bank margins, and a probable recession by the fall.
This is a different investment environment. One that may most resemble the 1968 to 1982 period of up and down markets on the way to flat equity market returns.
More defense than offense. Raise cash on rallies.
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About Trade Signals
Trade Signals provides a weekly snapshot of current stock, bond, currency, and gold market trends. We provide a summary of technical indicators to help you identify where we sit in short, intermediate, and long-term cycles. We track important valuation metrics to determine the probability of future returns (i.e. when return opportunity is best/least). Trade Signals also tracks investor sentiment indicators and economic and select recession watch indicators. Trade Signals is now a low-cost subscription service, about the cost of two Starbucks lattes every month. You can find the archive of weekly Trade Signals posts (2008 through 2-15-23) by clicking here.
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Not a recommendation for you to buy or sell any security. For information purposes only. Please discuss needs, goals, time horizons, and risk tolerances with your advisor. Investing involves risk. You can lose some or all of your money.
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Personal Note: The Korn Ferry Tour – Club Car Championship Pro/Am
I have never been a good golfer. Arnold Palmer said. It takes time, patience, and consistency. Even with practice, you have to get a lot right just to be decent. Arnold Palmer took the same approach to life as he did with golf, and he was a master of both.
Arnie believed that the “golf course is a place where character reveals itself,” and he lived that belief during every game. His competitors frequently commented on his courtesy and friendliness, whether he won or lost. Fans admired his passion and determination. Sports commentators talked about his discipline and persistence. He will be most missed for his kind heart, charm, and likeability.
I thought about Arnie as I watched his grandson Sam Saunders hit balls on the practice tee at the Club Car Championship Pro/Am in Savannah, GA. His swing looked nothing like his famous grandfather. And that’s probably a good thing. I remember Susan commenting after she first saw Arnie’s golf swing on TV. “What was that…” That was one of the greatest ever to play the game. I hope young Sam’s heart is as big as his grandfather’s. What a wonderful human being he was…
“Swing your swing. Not some idea of a swing. Not a swing you saw on TV. Not that swing you wish you had. No, swing your swing. Capable of greatness. Prized only by you. Perfect in it’s imperfection. Swing your swing. I know, I did.”
Love that!
On the first hole of the Club Car Championship Pro/Am, Chase Seiffert’s tee shot went left of the fairway into the trees. Seeing a small opening towards the green, he looked at his caddie, Thad, and motioned to a 5-iron. Thad nodded in agreement and handed him the club. Standing next to him, I wasn’t so sure, so I asked Chase to walk me through his thought process—after all, “we were there to win this thing,” he said.
The format was to take the lowest net score on each hole, and the amateurs got to use their handicaps. So, if I shot a 4 on a par four and it was a stroke hole, I post a 3 or one under for the hole. For the Club Car Pro/Am, three amateurs are paired with a pro, making the day a practice round for the pros and great fun for the amateurs—especially if you’re paired with a pro like Chase. He was open, engaging, and quite fun. To watch him hit the ball up close is simply amazing.
Add up the best score on each hole from your foursome over 18 holes, and your team’s score competes against all the other foursomes in the tournament. Our team got -7 on the front nine and -8 on the back nine, which gave us a total of -15 under par.
Chase Seiffert is a 31-year-old professional golfer. He played college golf at Florida State University, where he was a two-time All-ACC selection. As an amateur, Seiffert became the first person in the history of the Florida State Golf Association to capture its triple crown—the Amateur, the Florida Open, and the Amateur Match Play Championships—all in the same year. In the 2016–17 season, he played in three PGA Tour events, and in 2018, tied for 9th at the Travelers Championship, which generated enough non-member FedEx Cup points to qualify him for the 2018 Web.com Tour Finals. He was promoted to the PGA Tour for the 2019–20 season. He’s now fighting to get back to the PGA Tour.
Of approximately 80 million golfers globally, only the elite 175, plus exemptions, qualify for the PGA Tour. This year, the top 30 finishers on the Korn Ferry Tour get promoted to the PGA Tour, and the bottom 30 from the PGA Tour get relegated down to the Korn Ferry Tour. Chase is currently ranked 36th on the Korn Ferry Tour.
Yesterday, the first day of the Club Car Championship, Chase played well.
Now, there are some fun scoring rules, too. Whatever the pro shoots in the tournament, their score gets added to the amateurs’ score for their team. Yesterday, Chase shot a 67 or -5 under par. That means our team—Team Good Guys—is sitting at -20 under for the tournament. Not too bad.
The best Pro/Am score on Wednesday was -31. The word “sandbaggers” comes to mind… But what are you going to do? (For non-golfers, sandbaggers are players who cheat on their handicaps.) I’m not sure how their team is doing now, but I know if Chase keeps going low, some cool swag may come our way. He couldn’t have been nicer to us, and we’re really pulling for him. A win will get him in the top 30 and one step closer to his dream of returning to the PGA Tour.
Go low, kid!
Here’s a look at Team Good Guys. (I know, I know—we should have consulted our wives on the white shirts…)
Steve, Mike Freeman and Greg Fox
A special thank you to Mike, Roger and Adin, and the entire Skyway Capital Markets team.
Beyond living out golfing dreams, spring has sprung (or almost) at home. The mulch was delivered today, and it’s time to start moving the patio furniture outside—much to do around the house. I’ll find a few podcasts to listen to while I tackle chores to take my mind off the banking mess. Let me know if you have any good podcast recommendations. Susan is away coaching her under-15 girls team at a soccer tournament in Virginia. I so enjoy her game updates. I’ll be rooting for both Chase and her girls this weekend.
Hope your favorite team is still alive in the March Madness tournament.
All the best!
Steve
Stephen B. Blumenthal
Executive Chairman & CIO
CMG Capital Management Group, Inc.
Private Wealth Client Website – www.cmgprivatewealth.com
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Stephen Blumenthal founded CMG Capital Management Group in 1992 and serves today as its Executive Chairman and CIO. Steve authors a free weekly e-letter entitled, “On My Radar.” Steve shares his views on macroeconomic research, valuations, portfolio construction, asset allocation and risk management.
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