I was looking last night at the performance of the main indices for 2023 through yesterday. They rank as follows:

NASDAQ +14.8%

S&P 500 +5.5%

Russell 2000 +0.5%.

I think the Russell 2000 is always an index worth keeping an eye on because it’s much more representative of the US economy than the other two, which have very large weightings in specific industries (like tech in NASDAQ) or exposure to foreign economies (which makes up roughly half the profits of the S&P 500).

So far this year, the general US economy has been the worst place to be. Better to have tech exposure or foreign earnings, which have been boosted by strong currencies vs. the US$. That’s partly because other countries are beginning to show some signs of economic vigor, mostly, though, because foreign central banks are beginning to withdraw stimulus–i.e., higher interest rates are causing many foreign currencies to rally vs. the dollar.

I noticed an online article the other day (Yahoo Finance?), reporting an interview with Cathie Wood of the ARK funds. Ms. Wood was apparently critiquing the major stock indices–NASDAQ and S&P 500, I think–for having old stodgy, no-longer-disruptive companies like the FAANGs in them. Odd, I thought. If the indices are so lame, that should make them easy to beat. One’s best course of action would more likely be to keep quiet about these deficiencies and accept credit for besting a low bar rather than trashing the benchmarks.

Then I looked at the indices themselves. Over the past five years, performance has been as follows:

NASDAQ +70.1%

S&P 500 +52.2%

Russell 2000 +15.5%

Ark Innovation (ARKK) -1.2%.

During the nine months following the early 2020 pandemic lows, ARKK quadrupled while NASDAQ doubled. ARKK gave back all that outperformance in the following year, and has been generally underperforming NASDAQ since, ex some signs of relative life during January of this year.

MU is a major semiconductor manufacturing company, focused on DRAM and NAND memory chips. It reported 2Q23 results (its fiscal year ends in August) the night before last. The results weren’t great, with the company–as I read the financials–around breakeven on a cash in-cash out basis, after initiating layoffs and a substantial reduction in capital spending.

The stock was up by 7%+ yesterday, despite this. How so? MU said that things had stopped getting worse. Some customers had begun to get their inventories of MU products under control, although aggregate customer inventories appear to still be higher than normal. And MU now figures that business will be back to normal sometime in fiscal 2025.

Conventional portfolio management wisdom is that this is how commodity-like stocks work–buy them when things look bad but are starting to turn, and remember to sell them when there seems to be nothing but blue sky ahead.

other stuff

One of the heads of Blackstone, Steve Schwarzman, appears to have said he thinks the failure of Silicon Valley Bank was due to cellphones.

The head of upscale home furnishings company, RH, Gary Friedman, appears to be blaming what he sees as erratic and unpredictable actions by the Fed for the weakness in his business.

Cathie Wood of ARK appears to be blaming the 70%+ fall in her ARK Innovation Trust portfolio since early 2021 on the Federal Reserve’s lack of “market” experience.

As one of its inducements for DIS to establish and develop Disneyworld, the state government in Florida granted control of most local civic matters in the vicinity to a commission to be staffed by DIS. After Disneyworld employees compelled DIS to issue a weak and belated defense of LGBTQ rights, governor DeSantis decided to punish DIS by replacing its commissioners with ones he controls–and which would presumably be hostile to DIS interests. The new commissioners have found, however, that the old commission transferred virtually all its powers to the Disney company just before being disbanded. My guess is that the curtain has only gone up on this drama, which could end up having major repercussions.

In this post, I’m going to use the ticker, SIVB, that Silicon Valley Bank used before it was shut down and sold.

—-Perhaps the oddest single thing about the SIVB debacle is that it was a publicly traded company, whose detailed financials were publicly available both on the SEC Edgar site and, I presume, on the company’s website. So everyone with an interest in the bank could easily have understood that SIVB was unusual in two respects:

–the average account size, including corporates, was about $4 million, with something like 90% of all deposits not eligible for FDIC insurance, and

–the majority of the bank’s assets (i.e., the way it invested depositors’ money) were in long-dated Treasury bonds. To my untutored eye, the company didn’t have much of a conventional bank lending business and apparently saw no need to develop one.

—-Most of the deposits came into SIVB during 2020-21. To make a 75 basis point spread between interest collected from Treasuries and the zero-ish interest paid to depositors, SIVB would need to buy 7-year–or longer–Treasury notes. In contrast to conventional, variable-rate bank loans, the interest payment on Treasuries is fixed. And the lender can’t have a loan committee meeting and thereafter demand immediate repayment. So the 1%-ish T note rate was locked in for a very long time.

This strategy might have made sense during the deflationary1990s in Japan, or if you thought the pandemic might continue for another four or five years. Absent either, a 1% long-dated Treasury was about the worst thing you could buy.

So SIVB customers were uniquely uninsured and the bank was in a poor position to meet withdrawals. All of this when the Fed was making it ultra-clear that rates were going to up by a lot.

—-Another weird part is that neither the tech corporation VP finances nor the high net worth individual customers bothered to take a peek at the SIVB financials–or they did and didn’t care about the risk they were taking.

—-The Fed and its San Francisco branch (the SIVB CEO was a board member of the latter) did care. Both apparently warned SIVB of the huge risk it was taking, and were ignored. Both now maintain that they could only advise and not force SIVB to comply. The Financial Times recently reported that the Bank of England was worried enough about the risk to the financial system that SIVB posed that it wrote to both Feds to express its concern.

—-In late 2022, Kim Olson took the job of SIVB’s Chief Risk Officer, a position that had been vacant for some months (also weird, and arguably very revealing). Why would someone with her 30 years of risk management experience take this job, since even a back of the envelope calculation would have suggested that the losses on Treasuries (unhedged, apparently by SIVB design) from rising interest rates had wiped out all, more or less, of SIVB’s shareholders equity? At the very least, something had to be done immediately, in early January (again, easy to say now).

—-this morning I happened to be watching CNBC when Joe Kiernan “explained” that the failures of SIVB as a company and the San Francisco Fed as a supervisor were understandable, because both have women in positions of responsibility. He forgot to mention Jim Cramer’s forceful endorsement of SIVB on CNBC at $300+/share in February.

pre-Spring housecleaning in the banking sector

Silicon Valley Bank

For Northern California entrepreneurs, having a Silicon Valley bank account was like sporting a Birkin bag or driving a Porsche–a clear signal that you’d made it.

Unfortunately, it was also almost inconceivably badly managed as a bank. A huge portion of its investments were in long-dated Treasuries, bought when interest rates were close to zero and unhedged against the possibility of higher interest rates. This meant losses were inevitable as the Fed normalized interest rate policy as the pandemic waned. Warnings from government regulators and outside consultants about this risky posture, as well as the lack of management information systems, were ignored.

Adding to risk, the bank was very highly vulnerable to the possibility of mass withdrawals on the deposit side of the balance sheet. That’s because the average account size was $4 million, meaning 90+% was above the $250,000 limit for being eligible for Federal deposit insurance.

More than that, Jim Cramer of CNBC touted the stock as “cheap” at $320 a share a month or so ago.

The house of cards came crashing down as the bank began to have gigantic withdrawals–reportedly $42 billion in a single day–and a belated attempt to raise new funds failed. The bank was closed by the authorities ten days ago.

Credit Suisse

CS has been the bad boy of Swiss banking for as long as I can remember. It wasn’t a case of plain vanilla incompetence in asset-liability structure the way it was with Silicon Valley Bank. It was more the company it kept–drug dealers, money launderers, fraudsters of all ilks. None of that did the bank in, though. It looked like it would be able to continue to limp along, until the announcement by its largest shareholder, the Saudi National Bank, that it wouldn’t/couldn’t provide more equity to help address potential liquidity problems. The result was a government-forced acquisition by UBS at a price that all but wiped out existing shareholders.

One twist in the story: contingent convertible bonds. These are weird (to my mind, anyway) instruments that have been around for decades. Traditional convertibles are income instruments that are issued at a discount to prevailing rates, offset by an option for the holder to convert into stock at, say, a 30% premium to the issuer’s stock price at the time of the offering. So if good things happen, the holder is rewarded. Contingent convertibles, called “co-cos” or AT1s, do the opposite. They are issued at a premium interest rate, with an issuer option to convert them into common stock if the underlying business goes south.

I’ve never understood the attraction.

Credit Suisse had $17+billion of the se on its balance sheet. They’ve all been converted, wiping that debt away.

where to from here?

Morgan Stanley, which had predicted a US equity index fall of up to 25% during the first quarter and gradual improvement after than, appears to be saying that banking woes are the canaries in the coal mine or, to mix metaphors, the first of many shoes that will drop in the near future. My sense is that we’re much closer to the end of bad news than that.

The big winners during all this have been cryptocurrencies and beaten down tech stocks. So far this year, the Russell 2000 (pure US earnings) is flat, the S&P (half US, half foreign) up slightly and NASDAQ up by about 10%. I’d be happy with a flat market from here, where stock and industry selection would be paramount.

I’ve been reading a New York Times article on SIVB this morning. The original version came out yesterday and was amended today to state that SIVB had gotten a call from the ratings service Moody’s was going to downgrade SIVB’s bonds to junk (the earlier version had mentioned other securities).

What I take from this is that the bond community knew clearly what a risky mess SIVB was.

The article also cites a Janney Montgomery Scott report on the stock that 75% of SIVB’s investment of depositors’ money in Treasury bonds (a category that made up the majority of the bank’s investments) was classified as “held to maturity.” This classification means that the bank would carry them on its financial statements at their purchase price, rather than marking them to market and recognizing the resulting gains or losses on the income statement. And the categorization would normally be used only for bonds that would mature at least several years in the future. This compares with the typical bank, which classified 6% of its debt portfolio this way.

Why the enormous difference? Two possibilities come to mind: either most banks used hedging techniques that have been common since at least the 1980s to protect them from rising rates or they chose not to make the huge bet that SIVB did that interest rates would stay at pandemic lows for years.

The fact of this brokerage report outlining SIVB’s unusual and aggressive bond bet suggests that professional equity investors also knew what about SIVB’s ill-fated bet.

Who didn’t know the very worrisome data in SIVB’s financial statements and in bond and stock reports? Apparently lots of Silicon Valley startups, affluent California individuals, Roku, actors playing the role of investment professionals on shows like CNBC’s.