When investors comment on how a market performed over a given time period, whether a day or a year, they generally are referencing the performance of a basket of stocks, like the Dow Jones Industrial Average or the Standard & Poor’s 500 Index.  These particular indices are useful both because of their longevity and also because they are thought to accurately reflect the broader stock market, which in turn is thought by many to be a good reflection of economic forecasts.  But there are times when the movement of an index can be a bit misleading or send a confusing signal.  Stock price movements are not always a proper reflection of economic forecasts, especially over shorter periods of time.  And an index, depending on how it is composed, does not reflect the average price movement of most stocks within it.  The first half of 2024 has been a period where one index in particular has not, in our view, mirrored changing economic expectations, and certainly has not been a measure of the average stock within the broader market or even the index itself.

The S&P 500 Index climbed over 15% in the first half of this year.  This is a historically strong return, and, without further investigation, one might conclude that the stock market generally was very strong and perhaps that the economic outlook was improving.  Yet the first half of the year has been marked by moderating expectations for economic growth, a weakening housing market, and slowly rising unemployment.  Many companies that sell directly to the consumer talk of financial stresses emerging, especially among lower-income customers.  It is generally a challenging environment for many companies and share prices reflect this.  The average stock in the S&P 500 is up 4.7% in the first half of the year, the venerable Dow Jones Industrial Average is up 4.8%, and the Russell 2000 Index, a measure of 2000 smaller- and medium-sized companies in the stock market, is up only 1.7%.  These are all a far cry from the 15% return on the S&P 500 Index.  To understand how these figures could be so far apart, and why the most cited measure of stock market performance, the S&P 500, could be so far above most companies, it is critical to note that the Index weights performance based on the size of the company.  The performance of larger companies has more impact on the Index than the performance of its smaller members.  And thus far in 2024, this discrepancy between large and small has been stunning.

At the end of the 2nd quarter, there were six companies in the U.S. stock market that were valued at over a trillion dollars: Microsoft, Apple, Nvidia, Alphabet (Google’s parent company), Amazon, and Meta (Facebook’s parent company).  All are technology companies, and together they make up nearly a third of the entire market when measured by size.  Their performance in the first half of the year contributed 10% to the overall return of the market, which quickly explains how the S&P 500 climbed 15% when the average stock rose less than 5%.  Nvidia alone accounted for much of that strength, as it single-handedly pulled the entire S&P 500 Index higher by 5%.  It is unusual for the largest companies to so dramatically outpace their smaller peers.  There has not been this concentration of market strength amongst the largest few companies since 2000 in the dot-com bubble.  From that point forward, all of those shares (companies like Cisco, Nokia, Worldcom and Lucent), stalled under the weight of enormous expectations or disappeared entirely.  From 2000 onwards, the average stock in the S&P 500 outperformed the Index over the next fifteen years, while the largest companies acted as a drag on market performance.

Cisco is a particularly interesting case study.  In 2000, Cisco’s prescient and animated CEO, John Chambers, described the landscape as follows: “business and government leaders are beginning to dramatically transform their traditional business models into Internet Economy business models.  These new Internet-based models reduce costs, generate revenue in new ways, empower employees and citizens, and provide the agility needed for the Internet Economy’s rapid pace.”  Cisco stood at the center of this transformation with its networking equipment and briefly became the largest company in the world.  Twenty-five years later, and the company is still the largest networking company in the world, but its shares have never regained the highs they set when Chambers made these comments.  An investor buying into the enthusiasm in the Spring of 2000 would still be sitting with a loss today.

Nvidia feels similar in many ways.  It is a semiconductor company run by a brilliant and ambitious CEO, Jensen Huang, who just recently made this comment to investors: “The next industrial revolution has begun – companies and countries are partnering with NVIDIA to shift the trillion-dollar traditional data centers to accelerated computing and build a new type of data center – AI factories – to produce a new commodity: artificial intelligence.”  Nvidia has already had massive success selling its semiconductors to AI customers, and it may go on to have continued business success, just like Cisco did.  But this moment may also represent the high water mark for its shares, just as 2000 was for Cisco.  And it is important for investors to be mindful that, at the moment, the S&P 500 Index is much more a story of Nvidia and its largest tech peers than the other 494 companies that make up the entire Index.

Current Strategy

It is a difficult time to keep pace with the S&P 500 Index.  To match its composition, an investor would have to have roughly half their money in technology companies, with most of that in companies that are connected to Artificial Intelligence (AI).  That is a rather extreme concentration in one theme, but that is the structure of the Index at this point.  The valuations in this AI theme are quite high, driven by lofty expectations for future growth; and because they dominate the Index, this has driven the valuation of the entire Index to a high level.  However, the exceptionally strong performance of a few stocks leaves many other stocks out of favor, so some opportunities exist, and are emerging, for an investor looking for decent values.  

Consumer spending is slowing, especially when looking at larger, more discretionary purchases.  This has resulted in large declines in the shares of many consumer-oriented companies.  But spending is cyclical, and soft spots, like we are in now, often create a good entry point for investors hoping for good long-term returns.  In the last quarter, we added to our exposure to consumer stocks, and we will look for more opportunities in the months to come.  Also, the rush into AI stocks has been so extreme that it has pulled money away from technology companies that are not deemed to be part of the AI theme.  Investor money is leaving these software and hardware companies, resulting in better valuations.  The potential exists for a fracturing of tech into AI “winners” and “losers” large enough to create opportunities to buy shares in high-quality technology companies, whose only shortcoming is that they do not resemble Nvidia or OpenAI (a leading developer of AI technology).  In 2000 there were good opportunities in a high market.  They were not plentiful and required careful stock picking, and investors still had to be very careful to not become over-exposed to a market that was generally unattractive.  We hope to employ that same judiciousness in this market, as the ideas above illustrate possibilities that may exist for an investor looking beyond the handful of AI stocks that are driving this market.

Slowing economic conditions have been matched with slowing levels of inflation.  It appears the Federal Reserve has finally neared its goal of tempering inflation towards an acceptable level.  Slowing consumer spending and an uptick in unemployment are some of the painful remedies often required to cure an economy of high inflation.  What remains to be seen is if this time the job can be done while still avoiding a recession.  With lower inflation, the bond market has finally gotten the signal it was looking for, and most bonds have started to rise in value, with yields dropping slightly.  We entered the quarter with what we believe to be a generally full bond portfolio for most clients, and there was little fixed income investment activity as a result.

When economic conditions are deemed to be benign or favorable, investors will often get aggressive, placing very high values on future profits that may or may not materialize.  Declining inflation and hopes for interest rate cuts buoyed stocks in the final two months of 2023, and that enthusiasm carried through the first quarter of 2024.  After two years of sharp declines and subsequent rallies, the S&P 500 Index finally broke above its previous high watermark set in 2021.  But now the entire rationale for the first quarter rally has been thrown into question as hotter inflation has reemerged and interest rates have risen accordingly.  Just a few months ago most investors anticipated seven interest rate cuts in 2024 – the current expectation is for one or none.

The Federal Reserve has been hoping for that perfect mix of economic forces that tempers inflation to the two percent level, without pushing the economy into a recession.  At the moment, they are still falling short of that first goal, as inflation has been holding steady above three percent and is more recently pushing back towards four percent.  The job market is tight, boosting wages.  While this is a good thing for most people, it complicates Fed policy by raising inflation.  Exacerbating the challenge is a fundamental shortage of housing, which has kept prices elevated in many locations, despite higher mortgage rates.  Housing costs are the single biggest input to the inflation indices, as housing is the biggest expense for most people.  There is no sign that prices will moderate any time soon.  With wages and housing prices working against the aims of the Federal Reserve, the central bank has altered its language in recent months and indicated that it will move more slowly than expected in lowering interest rates.  

The level of interest rates has a big impact on the valuation of both stock and bond prices.  Warren Buffett is quoted as saying “interest rates are to stock prices as gravity is to matter”.  In other words, higher interest rates should exert a downward pull on stock prices. But that didn’t happen in the first quarter of 2024.  Rates rose from a low point at year-end without denting the stock market rally.  Investors shrugged off the interest rate rise and continued to believe that the Fed was still on the cusp of a rate-cutting campaign.  Those hopes were finally dashed in April as more hot inflation data was released.  Stocks began to fall, retreating some five percent.  Gravity seemed to be taking hold.  

Stocks, bonds and cash are always priced in competition with each other.  Lower yields on cash and bonds encourages investors to put money into stocks, while higher yields on cash and bonds makes them more appealing to investors, creating an alternative to stocks.  That is a simplistic, but generally accurate, outline of the forces that push trillions of dollars across these competing asset classes.  The average dividend yield on stocks fell to a paltry 1.4% in the first quarter, as higher stock prices translated into lower dividend yields.  Meanwhile, the yield on short-term Treasury bonds, considered the safest of investments, remained above 5%.  That is a tough mathematical comparison for stocks, so it is not surprising that stock prices have retreated in recent weeks. 

Current Strategy

The stock market rallied hard in the first quarter of 2024, spurred on by expectations of a big shift in Fed policy.  Investors assumed that rate cuts would start in March and then occur regularly throughout 2024.  But so far there have been no interest rate cuts.  It appears that just the mention of possible interest rate cuts was enough to stoke a rally in stocks and bonds,  creating a wealth effect as investors looked at higher account balances.  This in turn led to more consumer spending, preventing inflation from falling to the Fed’s two percent target.  The Fed has tied its own hands as it can’t lower rates in the face of renewed inflation.  The shift in Fed policy was simply an illusion.  It remains to be seen how a market rally based on an illusion unfolds during the remainder of 2024. 

We did not find our preferred set-ups for stock purchases in the first quarter of the year.  We did take some profits in the rally, in most cases trimming back on some large gainers as opposed to an outright sale of the whole position.  And we continued to hold substantial portions of accounts in short- to intermediate-term bonds and money market funds.   With bonds and cash yielding in the 4.5% to 5.25% area, depending on the maturity length of the paper, we felt that waiting for better stock buying opportunities made sense.

Bond yields are rising again on longer-dated maturities, making bonds an increasingly attractive alternative to cash.  At some point interest rates will most likely fall, but maybe not in 2024 as previously expected.  A recession or geopolitical events that hurt economic activity could trigger a rush to bonds.  The exact catalyst for a drop in interest rates is hard to predict and could catch most investors by surprise.  It is wise, in our opinion, to be in position with some intermediate-term bonds before such an event occurs.  The opportunity to build a reliable, base return of about 4.5% to 5.25% per year for several years or more is currently available, but that may not always be the case.

The final two months of the year saw a significant rally in both stocks and bonds. A market that
had been extremely thin, resting on the strength of only a handful of companies, broadened to
include a majority of stocks, which was a welcome development for many investors. And after
languishing all year, bonds began to recover. Prior to this rally, 2023 was proving to be another
frustrating year for most investors, save for those whose portfolios leaned on a small basket of
technology stocks. But after the late rally, which included a much wider array of industries and
asset classes, most investors could view 2023 as a successful year.

What investors found so encouraging was both an improvement in the economic data and an
improving narrative around that data. Investors are constantly shaping narratives to fit new
data as it emerges, and often the narratives turn far more quickly than the underlying data.
Stock and bond investors have now settled into a rosy view of a “Goldilocks Economy,” in which
growth that is neither too hot nor too cold avoids the twin risks of inflation and recession. For
the moment, the temperature is just right: employment and consumer spending have improved
slightly, while inflation continues to moderate and the Federal Reserve has begun to talk in clear
terms about interest rate reductions. Looking back, it was this turn in narrative from the Federal
Reserve, in November and December, that allowed investors to develop more positive narratives
of their own. The odds that the central bank can reign in inflation without provoking a recession
are increasing, a scenario that seemed unlikely a year (or even a few months) ago.

There are some dangers to a market rally built on this foundation. Most notably, inflation is still
well above the Federal Reserve’s stated goal of 2%, and the most recent reading of core inflation,
stripping out food and gas prices, was actually a touch above expectations. If the Federal Reserve
has to keep rates at the current level beyond this spring, that would be an unwelcome surprise.
A recession seems like less of a concern at the moment, but investors will want to see a good
economy reflected back in corporate earnings. Many companies were impacted negatively last
year as price and wage increases took a toll on profit margins. Profitability should improve this
year, but so far many executives have been cautious when providing their outlooks for 2024.
One reason for this is that for many large U.S. companies, China has become a very important
market. Demand there is weak and it is hard to forecast an improvement, which cuts against an
improving view of the domestic economy.

Yet these dangers pale in comparison to the fears that gripped the market early last year and
again in the fall: that the economy would topple into a stagflationary mix of recession and
stubbornly high prices. Such a mix is historically toxic for stocks and bonds. Fortunately, we
believe it can be discounted with improving data. The temperature may not be perfect going
forward – and it is quite easy to point to a rally that has gotten slightly ahead of itself – but the
danger of getting badly burned in the near term seems diminished.

Current Strategy

If the temperature stays just right for investors in 2024, it should call for a broadening of the
current rally. It is important to note that the Russell 2000 Index, a basket of smaller companies,
is still 20% below its all-time highs. So, even as the largest tech giants soar to new heights,
a large swath of stocks are still technically in a bear market. This mix of smaller companies
typically carries more cyclicality and volatility, but an improving economic outlook and benign
inflation would be just the mix required to push shares higher. While we find much of the
technology sector to be overheated on premature enthusiasm for AI, we believe this does leave
other parts of the market reasonably priced.

There is an aspect to this market that calls back to the tech bubble of 2000. We have made
this comparison sporadically in recent years, but increasingly there feels like a single path to
investment success. The enthusiasm for tech stocks appears to be sucking oxygen out of the
room for other corners of the market. There is only so much money to allocate to stocks, and
on many days of late, the success of technology stocks is matched by declines in other sectors.
If the economic outlook is improving generally, it would point to success for a diverse mix of
companies and industries. While the rally did start to broaden a bit at the end of the year, a
benign environment should provide ample room for this broadening to continue, with so many
stocks still struggling for any investor attention in the shadows of the tech giants.

The bond market rallied significantly as the Federal Reserve changed its language in November.
Prices climbed, sending yields lower on longer-dated bonds. Yields on much shorter-dated
bonds will fall as well, but only when the central bank lowers rates. The timing of this is up for
some debate at the moment, both amongst investors and amongst the twelve Federal Reserve
members who set policy. But the bank is likely to begin cutting rates sometime in the spring or
summer, based on the consensus view and commentary of its voting members. While short-term
rates will fall, we question whether long-term rates will continue to decline as well. At a certain
point, a good economic outlook should support higher long-term rates. In robust economic
times there is a demand for money, and all borrowers, including the U.S. Government, have to
compete for lenders. This has meant historically that 10-year Treasury bonds often command
yields of 4-5% or higher. A return to normal, both in regards to inflation and economic growth,
would signal that the bond rally has left longer yields in about the right place. If this is true, even
as short-term yields decline for fixed income investors, they will hopefully have the opportunity
to build out a longer-dated bond portfolio at yields that are in line with historical levels.
Critically, we do not anticipate a return to the era of super-low yields for fixed income investors
if the good economic outlook holds in 2024.

There has been growing adoption of new weight-loss drugs throughout this year, driving enthusiasm for the two manufacturers of these drugs, Eli Lilly and Novo Nordisk. After a year of strong gains, these two companies are now the first- and third-largest healthcare companies in the world as measured by market capitalization. Novo Nordisk’s success is so significant that it has single-handedly raised the economic outlook for the entire country of Denmark, which is where Novo is based.

The success of the weight loss drugs has set in motion a counter-trend for many other medical companies. On July 20th of this year, a seemingly innocuous comment from Intuitive Surgical, the leading manufacturer of robotic surgical equipment, triggered a widespread move in dozens of leading medical companies when the company announced it had seen a slight softening in demand for bariatric surgeries. The language was measured, but the stock market was swift in its reaction. Shares of Intuitive Surgical, and many medical equipment peers, began to fall in July.

Investors have now started to map out a new megatrend within the economy and stock market. Their assumption is that the world is going to be reshaped by widespread adoption of weight-loss drugs. Eli Lilly and Novo Nordisk have continued to gain momentum since the summer, while the list of medical companies losing value has grown longer and longer. Shares of medical companies treating sleep apnea, diabetes, heart disease, and kidney failure have all plummeted, some by as much as 50% in just a few months. Makers of knee and hip replacements have lost a quarter of their value, as investors contemplate a population putting less wear and tear on their joints. The entire medical equipment sector within the S&P 500 has declined by roughly 30% since the end of July. More recently, makers of packaged foods and restaurants have joined the decline. Shake Shack, Pepsi, Utz Brands, and Kellogg are just a small sampling of food companies that have lost nearly a quarter of their value or more in recent months. Food packaging companies are declining, as are companies that sell equipment to restaurants.

Much like the enthusiasm around artificial intelligence (AI) that we wrote about in the summer, the excitement over weight-loss drugs has a legitimate foundation. The clinical effects of these drugs are significant. A follow-up trial by Novo has shown that Wegovy, its leading weight loss drug, can reduce heart attacks and strokes in certain populations. Widespread adoption certainly has the potential to alter medical care and, to a smaller degree, food consumption. But as with AI, the impact within the stock market seems overly swift and exaggerated. Is society on the brink of seismic change that will alter everything? Or is there a reason why investors might be too willing to buy into that narrative and overextend themselves?

In our view, the macroeconomic backdrop matters tremendously in helping explain the emergence of two market megatrends in the same year. At the moment, the average stock is beset by two problems. First, interest rates continue to climb, which then pressures valuations for most companies. With investors able to get 5% in a money market fund or Treasury Bonds, many stocks simply have to get cheaper to remain mathematically compelling. And second, the economic outlook is atypically cloudy, with conflicting signs of strength and weakness throughout many pockets of the economy. The average stock in the market is on pace for another negative year at the moment, given the interest rate headwind and economic uncertainty.

Faced with these inferior returns, it’s understandable that investors would latch onto any narrative that seems simple and compelling. Whether that narrative concerns AI or weight-loss drugs, at a minimum an investor can say confidently that these trends will have some impact in the future. Of course, “impactful” is not the same thing as “transformative,” but in an environment where it has become quite hard to build confidence around most investment themes, it is not surprising to see investors potentially overplaying their hands when it comes to these two trends.

Current Strategy

The third quarter was challenging for stocks. The enthusiasm for AI stocks began to fade; most medical stocks were weak; and consumer staples companies fell sharply. The slide in most stocks has continued into October, as rising interest rates have exerted more pressure on stock valuations. Economic data continues to offer a mixed view on the economy, with the labor market remaining healthy even as consumer spending is under some pressure from rising interest rates. To illustrate the conundrum presented in the data, it seems most people are still able to find a good job, but more of their salary may be going towards 8% mortgages, higher rents or burdensome auto loans.

The set-up for many stocks and industries has not felt very compelling through the summer and early fall. For most clients, we were selling stocks in equal measure with any new buys. That is beginning to change, as the stock market churns lower and approaches a modest correction. More companies are showing the economic impact of higher rates, and earnings are starting to suffer, with share prices following them lower. In our view, the table is being set for a more prolonged, durable and widespread recovery in stocks in the future. For many clients, we have a lot of cash on hand, setting us up to begin stepping back into the stock market. But as always, we will invest in stocks judiciously, especially recognizing the current value of cash that yields above 5%.

The bond market may be nearer an inflection point. The shorter-term end of the bond market has not moved materially now for several months. There are growing expectations that the Federal Reserve is near the end of its rate hiking cycle, and the primary question now is how long they may keep rates at current levels. Inflation is declining, although the Federal Reserve would like to see it decline more significantly. The long-term end of the yield curve (typically bonds that mature in 10-30 years) is struggling, and yields are rising. Investors can now get reasonably good rates of interest for the next decade. Committing money for that long can be scary, and cash, at the moment, is just as rewarding. But it is not likely that cash yields will stay this high forever, and fixed income investors must plot years into the future. With some bonds maturing very soon, we are looking to extend the maturity of the fixed income portfolio for clients to ensure that we can earn a good rate of interest for years to come.

Through much of last year, technology stocks dragged the market lower. There were many
reasons for this underperformance, but put simply, investor expectations and optimism for the industry had run well ahead of reality during the pandemic. In light of these heavy corrections, it is not surprising that they have rebounded this year. What is surprising is the extent to which the technology sector has recovered – to the exclusion of most other industries – making for a very narrow, but powerful rally in the stock market. This recovery, sensible at first, is now looking more like a flood of momentum buyers hoping to cash in on a singular theme: artificial intelligence.

In January of this year, Microsoft announced a $10 billion investment in a new company called
OpenAI, which had released a trial version of its product, ChatGPT, late in 2022. This trial served as an introduction for many to the potential of artificial intelligence (AI), and Microsoft’s large investment signaled to the stock market that this relatively unknown company and their new product should be taken seriously.

Six months later, nearly every major technology company has framed their business and long-
term outlook within the context of AI. Many companies have come to market with competing or complementary offerings, and the stock market overall has added trillions of dollars of market
capitalization that can be traced back to this singular theme. The seven largest companies in
the S&P 500 Index, all technology companies (Apple, Microsoft, Alphabet, Amazon, Nvidia, Tesla, Meta), have spent considerable time and money this year connecting themselves to AI. In the first half of 2023, the shares of these companies increased collectively by 60%, at a time when most companies in other industries barely budged. Put another way, in an index of five hundred companies, the return from these seven companies made up three quarters of the return of the entire index, such was the enormous impact of their price rise.

To help understand the enthusiasm (and criticism) around AI, it may be useful to attempt a
rudimentary explanation of the technology. ChatGPT is a piece of software constructed around
a massive repository of language, i.e. digitized libraries and Wikipedia entries. A user will ask a
question or give a prompt, ChatGPT will analyze its library, and, in an extreme simplification, it
will deliver the response it deems most likely or probable based on the prompt. This approach and sometimes the result – can be at odds with the attachment most of us have to there being a “right” answer to a question. ChatGPT and other products like it are not searching for any right answer. They have been exposed as giving a “wrong” answer to somewhat simple questions, and at the same time giving incredibly interesting responses to equally complicated prompts, almost feeling “creative” in the process. Despite their faults, these are impressive feats of technological innovation – although the last decade has shown that not every technological feat necessarily produces social good or meaningful economic output.

Still, the stock market has added trillions of dollars of value this year. Companies providing the
computing infrastructure to build these powerful tools have soared in value; companies that
are building competing models to ChatGPT have generated excitement; and any technology company that can argue for a compelling end-use case has also attracted investors. From a personal assistant that can draft emails, to a well informed AI-driven “travel agent” that can create an itinerary, to a program that can potentially write the lyrics to the next hit pop song, the economic possibilities are compelling.

And yet, as with most big and compelling investment stories, there comes a point when
enthusiasm exceeds reality, and momentum buyers looking for a quick profit start to enter
the fray. We need only look back two years to see the last time this happened. In a world of
pandemics, it was thought, we would only shop online and we would all check in with our doctor via Zoom, in between numerous other virtual experiences. Undoubtedly, our lives post-pandemic are a bit different, and a bit more dependent on technology. Yet the shares of many pandemic-themed companies surged in a buying frenzy that collapsed even more quickly.

There will certainly be durable winners from the deployment of ChatGPT and its competitors.
It will change how we use existing technology. It will be valuable when used for good, and
dangerous when used poorly or to devious ends. But it is also likely generating too much enthusiasm within the stock market at present, driving the technology sector to massive short-term gains that may be difficult to sustain.

Current Strategy

The stock market has felt broadly split between the winners within the technology space and
everything else, with shares of many companies only inching forward this year. Although
our existing investment portfolio and new investments made in 2023 mostly fell outside the
technology sector, we managed many good successes to start the year in a variety of other
industries. We added investments in the healthcare and industrial sectors along the way,
although in each case the ideas were the result of unique opportunities we saw, rather than an
embrace of any broad thematic or economic outlook. Hopefully, we have structured a portfolio
of investments that stands to benefit under a broad range of economic outcomes or market
shifts. Today the S&P 500 Index has increasingly become exposed to the technology sector, and we are concerned that the largest companies are becoming overcrowded by investors buying shares directly – activity which is then amplified by the ETFs and other funds that match the Index in its composition.

As the stock market rally has gone on, we have found opportunities to take some gains and shift
funds to cash or bonds. With yields on cash and short-term bonds nearing 5%, the bar is set
higher for stocks to exceed that return. We view the math as challenging for stocks, at a time when the economic outlook is still cloudy and the largest sector within the market is showing signs of stretched valuations. While some investors continue to pull cash from the sidelines and pile into the most popular stocks of this market, we feel it is increasingly important to lean the other way. We have sold a few positions that feel most economically exposed, and have either built up some defensive positions (in healthcare, for example), or left the proceeds in cash.

This chapter of economic history is not yet finished, and it remains to be seen whether it will
finish like all past episodes of inflation-fighting via interest rate increases – with a recession – or if there is a different and better end in store. The current data is mixed, in our view. Economic forecasting is always guesswork, and sometimes even a proper view of the present is left to the eye of the beholder. We see an economy where employment is generally strong and inflation is still high, but clearly headed in the right direction. We also see an economy where many consumers are underwater on car loans, bank lending is tightening and consumer spending is constrained. Until we have a slightly clearer view on where we are and where we may be headed economically, the safety and income provided by cash and bonds is compelling, especially as the stock market approaches its old highs.

The month of March began with a quiet announcement from a relatively unknown bank called
Silvergate Bank. The “bank” was as much a cryptocurrency exchange as it was a conventional
bank, and their troubles had been evident since the collapse of various cryptocurrencies in
2022. On March 1st, Silvergate announced they might not have sufficient capital to continue.
The share price collapsed, depositors started to flee, and a week later the bank was insolvent.

The pace of that first decline felt glacial compared to what happened next. The same day
Silvergate officially went bankrupt, Silicon Valley Bank, the country’s most prominent lender to
the private equity and venture capital world, announced it would raise money by selling new
shares of its stock. The need to raise money set off alarm bells, and its depositors started to
withdraw money. The next day, $42 billion left the bank, with $100 billion lined up to leave the day after. Before that could happen, the bank was seized and put under the control of the FDIC.

In the span of just thirty-six hours, the U.S. had suffered its second-largest bank collapse in
history. Within the banking world, a weekend of panic ensued, capped off by Signature Bank,
another prominent lender to the cryptocurrency world, becoming insolvent. In the span of just a few days, three banks had closed, representing the most significant bank panic since 2008.

In the weeks since, the shares of a handful of banks have suffered tremendously, while the entire sector has struggled to regain investor confidence. First Republic Bank, most notably, has
required assistance from other banks and, at times, has seemed on the brink of becoming the
next insolvency. But even as First Republic Bank suffers, the contagion that swept through the bank sector for a week in March seems to have run its course. Many banks have reported their
results for the first quarter of the year that show resilience and allay the worst fears harbored in
March. Yet, with the height of the panic now likely behind us, bank shares have recovered little
meaningful ground, and investors remain skittish. To understand why, one needs to understand
the underlying causes of the bank panic. Given the specific banks that failed, it would be easy
to link the panic to the cryptocurrency collapse, or to the larger decline of the venture capital
industry in 2022. But this analysis misses much of the nuance, and too easily relegates the
problems to a few unique banks.

To fully see the larger problems affecting the entire banking sector, we return to the dominant
economic narrative of the last eighteen months: high inflation and rising interest rates. For banks, rising rates are proving to be a double-edged sword. Higher rates make it increasingly
productive for customers to move their money from checking and savings accounts into
higher-interest Money Market Funds, or short-term Treasury Bonds. This movement, in turn, is
beginning to drain bank deposits. The shift is occurring slowly at most banks, but as highlighted
above, at a few institutions it was cripplingly fast. And all banks now must suffer through
continued outflows or raise rates for their depositors, which hurts profitability.

Rising rates have also exposed poor investment decisions made by some banks in 2020 and
2021. During those years, a number of banks decided to invest some deposits into longer-dated
Treasury Bonds. This decision presumed that interest rates would remain low for a prolonged
period of time, but within a year these bonds sat at a significant loss. Now, as deposits leave,
the most pinched banks are forced to sell these bonds to generate the necessary funds for their
departing customers.

The bank panic may be over, but these larger issues, especially that of declining deposits, will
continue to exact a toll for months to come. And a critical byproduct of this episode will almost
certainly be increased conservatism on the part of most banks. If a bank is worried about
slipping deposits, it will naturally not lend out quite so much money. This will in turn act as
another brake on the economy, since bank lending is one of the key cogs in the machinery of
economic growth. Recessionary expectations have increased through the month of March; this
can be attributed almost entirely to the problems exposed by the bank panic, and the problems
it continues to create. An economy that was already fragile, as a result of rising interest rates,
will now have to contend with a cautious banking sector as well.

Current Strategy

The stock market staged a recovery in January and February, as it appeared that inflation was
more convincingly on the decline. Inflation served as the primary headwind for the market
during a tough year for investors in 2022. Any fresh signs that inflation was moderating
would naturally be received enthusiastically. Then the bank turmoil hit in March, temporarily
wiping out all progress the broader market had made on the year. We saw the beginnings
of an opportunity and made some new stock investments, while increasing the size of some
existing investments. While our investment actions in March do reflect a little risk-taking and
opportunism amidst a panic, we continue to balance our stock exposure with considerable
reserves in money market funds for most clients. This seems prudent given the heightened
chances of a recession some time this year.

Stock prices have recovered since the lows in March, as has our investment portfolio. Yet it
is telling that since the lows of the banking panic, among the best performing sectors in the market are healthcare companies, consumer staples and utilities. Meanwhile, the financial
and industrial sectors are almost unchanged, and shares of many banks and manufacturing
companies are setting new lows daily. The market is being lifted higher by the shares of
companies that are resilient during recessions, to the exclusion of many other companies.
This is not a rally in stocks that speaks to investor confidence in an improving economic
outlook.

The recovery in the bond market this year has felt more convincing and durable than the
recovery in stocks. Inflation is falling, although not quite as fast as the Federal Reserve might have hoped. But the banking panic and growing economic weakness provide a compelling
argument that central bankers have pushed far enough on interest rates. The Federal Reserve
must now seriously balance the health of the economy and the financial sector against the risk
posed by inflation. Bond investors think the Fed will pivot towards lower interest rates soon, as
economic risks force a more cautious approach. As these expectations of a pivot grow stronger,
longer-dated bonds are rising in price, continuing a rally that began late last year.