It’s human nature. When there’s an accident on the interstate, traffic slows to a crawl as passersby crane their necks, gawking to see who-knows-what. When the same occurs in the capital markets, pundits opine just as instinctively. Some think they can add insights to the narrative; others want to be on record for some future marketing blurb.
The principal contribution of the undersigned is neither. Our investment strategy—indelibly displayed in our client portfolios—has already been articulated in an irreversibly public way for a long period of time.
“I told you so’s” don’t hold much water for investment managers whose portfolios are and have been 80% or more invested in short-term U.S. Treasury securities, along with small allocations to catastrophic risk insurance. Picking an inflection point on the eve of the last dose of massive crisis-averting stimulus … the S&P 500 closed at 3230 on December 31, 2019. As I write, it’s 3915. MCM portfolios don’t have much to show for that 21%. We know of only one long-only firm that held cash when the COVID crash hit and then bought into the carnage. And it wasn’t us.
We’ve long argued that preparedness should take precedence over prediction. When debt and equity markets appear dangerously overvalued, as they have been for some time—10-year forward returns are in the mid- to low-single digits or worse, unless unprecedentedly heroic assumptions are made—clients must be willing in the meantime to forgo the gains that others enjoy. That’s a difficult pill to swallow. Portfolios begin to look like the accident on the interstate or, up close and personal, like the not-so-healthy guppy in the family fishbowl.
If Not Now, When?
Preparedness, to be sure, works both ways. Let’s begin with the email below that I sent at 7:42 pm on March 12, 2023 …
To a few friends on a Sunday evening:
It was precisely on this same March weekend in 2008, 15 years ago, that the past finally caught up with the present at the prestigious investment bank, Bear Stearns. In the famous play Julius Caesar, a soothsayer says to Caesar, “Beware the Ides of March.” The warning forebodes Caesar’s death later in the play. Today the saying is used as a general phrase of caution and warning. Of course, today’s Ides of March is likely to be nothing more than poetic coincidence.
What makes the Bear Stearns saga so fascinatingly apropos, however, is the manner in which the top-ranked investment bank cumulatively and increasingly irreversibly devolved into failure in the span of less than two years. My front-row seat was the vantage point from which to view the inevitable. For a well-written thumbnail chronicle, click on this hyperlink.
Aside from Washington’s weekend from hell in mid-September 2008, when Lehman and others gave up the ghost, might this past weekend prove to be another Ides of March moment? While most likely far from the enormity and consequence of that fateful weekend long since forgotten, it should be noted that for the financial and fiscal power elite in Washington, from Janet Yellen on down, the midnight oil has been burning. When the Secretary of the Treasury feels compelled to publicly pronounce that “all is well,” it gives one pause. Upbeat rhetoric notwithstanding, a stopgap bank liquidity plan is being cobbled together today (and tonight) before Monday morning’s market opening.
Despite Silicon Valley Bank’s incestuous tech-industry relationships, it was squeezed in a vise by a malaise visited on many financial institutions as the 10-year Treasury yield, a proxy, spiked from 1.2% to 4% over the last 12 months. The surge in deposits was greater than most banks’ ability to put them to work in variable-rate loans. Bank fixed-rate bond portfolios ballooned with the overflow. As bond yields rose sharply, bond prices sunk. SVB’s 36-hour failure, was the likely tipping point, exacerbated by a smart phone-based electronic run. Nowhere have we read that the authorities were aware of this possible problematic unintended consequence.
It was a long and agonizing six months between Bear Stearns and Lehman Brothers. Sentiment waxed and waned as the ship of destiny sailed deeper into troubled waters. While it’s a near certainty that the current storm will blow over, perhaps it’s wise to view flareups in a financial system plagued with systematic fragility as a canary in a coal mine? If this seemingly innocuous event is enough to put the authorities on full alert, should we be wondering about what lies over the horizon?
The decision about when to commit capital is the reciprocal of when to retreat. Typically, 10-year forward returns should be, to pick a number, no less than 10%. There is at least one caveat, though. In the event of extreme economic turmoil, a rarity, even mean reversion will be called into question. Despair from swings in the market breed pessimism about the future and stay the allocations of those being offered a once-a-generation opportunity. That’s why we use 10 years. It smooths the extremes.
Warnings Not to Be Taken Lightly
“Tip of the iceberg” or “canary in a coal mine” are phrases falling off pundits’ lips with the frequency of the snowstorms blanketing California this winter. Irrespective of their motives, such warnings should not be taken lightly. One scenario getting little press is a possible response of consumers and lenders to the raging and metastasizing uncertainty that has commanded headlines since the Silicon Valley Bank debacle burst into the public consciousness. Confidence can be fragile, and fear of the end of the easy-money dream can feed on itself. History would suggest that rising unemployment won’t be far behind.
Analogously, both consumers and creditors may stop to gawk, pausing their spending and lending as they survey the wreckage along the road. Simultaneously, suddenly higher interest rates have exposed the enterprises driving recklessly, flirting with the edge of propriety. And the surge in rates will surely reveal other hidden weaknesses. This is invariably the case after a period of easy money, accompanied by a spat of financial-sector deregulation.
When the roadside devastation eventually brings traffic to a stop, we may be seen hawking assurances of mean reversion to comatose drivers. When investment opportunities are legion, risk aversion paralyzes, and fear of loss is so psychologically debilitating, the pedal to the metal is to the brake and not the accelerator. It is in that moment—greater precision in timing would be irresponsible—that the seeds of the next low-risk, high-return investment environment will be taking root, like daffodils beneath the late-winter snow.