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.

The United States reached the congressionally authorized debt ceiling on January 19^th 2023. The Federal Government, which needs to borrow almost four billion dollars every day to meet its budgetary obligations, no longer has the authorization to borrow new funds through the issuance of U.S. Treasury securities. The raising of the debt ceiling is usually a formality. It has been increased 78 times since 1960, and was increased 17 times with little fanfare during Ronald Reagan’s Presidency. The last time the debt ceiling became a major issue was in 2011, during Barack Obama’s time in office. Present circumstances mirror 2011, with the House of Representatives controlled by the Republican Party and the Senate and White House held by the Democratic Party. This portends another nasty standoff over raising the debt ceiling. 

Everyone knows that the impasse over the debt ceiling will be resolved eventually. The Federal Government currently runs a deficit of about 1.4 trillion dollars a year, and borrows to cover social security checks, Medicare payments to the U.S. medical system, as well as paychecks for millions of civilian and military personnel. There is broad political consensus to continue all these programs and payments. A failure to raise the debt ceiling could also lead to a default on U.S. debt, which would destabilize financial markets and economies worldwide. Given the stakes, it is surprising that the debt ceiling has become a political football again, but the showdown reflects the state of American politics.

The political reality is that neither party is likely to get much of anything they want passed in the next two years. The Democrats accomplished some of their legislative priorities last year when they had control of Congress and the White House. The Republicans lost a Senate seat in the 2022 elections, and won a bare majority in the House. They will be unable to pass anything of any consequence with the Senate and Biden blocking their path. About the only thing the Republican-controlled House can do is launch investigations and continue the search for Hunter Biden’s laptop. But some have bigger aspirations than that, and see the debt ceiling showdown as an opportunity to impress their constituents. The Democrats think raising the debt ceiling is an obligation of the government, and should be done without controversy, as was the case when Reagan, Bush, and Trump were in power. The Republicans see the debt ceiling as a lever, and the Democrats are in no mood to be leveraged by a party that barely controls one legislative body. 

It is difficult to see how the standoff over the debt ceiling will end, even though it will at some point. Until that time, it is much like a game of chicken with two cars speeding at each other head-on with little inclination to veer away. Kevin McCarthy, who became the Republican speaker of the House by one vote after 14 failed attempts, will anger some extremists in his party if he even allows a vote on the debt ceiling without major concessions from Democrats. If he angers even a few members of his caucus, they will likely call for a new vote for Speaker and McCarthy will be voted out. The Democrats do not want to negotiate over the debt ceiling at all, and particularly not with someone seen as hostage to the extreme right. It may be that a collision is inevitable, and that a resolution will only come after economic damage has been done. The public should be prepared for months of posturing, as both parties try to pre-emptively pin the blame for any economic damage on each other. 

Brinkmanship over the debt ceiling in 2011 contributed to a drop in the U.S. Dollar, a rise in precious metals, and a sizable decline in stock prices that took months to reverse. It did not lead to a drop in value for longer-term government bonds. While investors were concerned about receiving their money in a timely fashion on bonds coming due in the summer of 2011, at the height of the crisis, there was little concern that any default would extend to bonds coming due months or years from that date. We are not sure that history will repeat, but it could be a guide. 

Current Strategy

While the debt ceiling may become a major issue for investors by summer, it was rampant inflation that drove a historically bad year for investors in 2022. The S&P 500 declined by nearly 19%, while the technology-heavy Nasdaq Index collapsed by 33%. Investors fled riskier assets, with hundreds of high flying stocks favored during the pandemic losing 70% or more of their peak valuations. The most widely held cryptocurrencies plunged in value, and lesser-known crypto coins simply disappeared. The red-hot IPOs (initial public offerings) of 2021 turned ice-cold, with most selling for a small fraction of their previous highs. Yet the broadest financial pain was felt in a far more stolid investment: U.S. Treasury bonds. One index of medium-length government bonds declined by over 12% last year. For many who rely on the stability of bonds, this decline felt seismic. It amounted to the largest yearly decline in bonds across more than a century of reliable data. 

Against that ugly backdrop, there has been some unequivocally good news in recent months. Inflation peaked in late summer and moderated through the fall and winter. With bond yields having reset to more normal historic levels and inflation no longer demanding such a draconian response from the Federal Reserve, bonds again seemed a stable and attractive investment option. We continued buying Treasury bonds for clients in the later months of the year, and captured the highest yields in 15 years. 

Stocks have also begun to recover off the low set in October of last year. But stocks still have one very large hurdle to overcome before they can stage a full recovery. Much of the progress on inflation has come because of softening economic conditions. Weaker consumer spending has induced price reductions for various goods, and the housing market is beginning to cool in many parts of the country. While lower inflation caused by slower economic growth is good for bonds, it is not necessarily good for stocks. Slowing growth can compress margins, as firms find themselves overbuilt and overstaffed. Sliding into a recession is historically damaging for stock prices.

We see many signs that a recession may emerge in 2023, and have therefore been less inclined to assume that stocks have bottomed. In general stocks tend to reach bottom during a recession, not before one has started. Consumer spending declined over the last two months of the year and layoffs are spreading, particularly in the high-paying technology industry, but so far the economy is not in a recession. While there is debate about the likelihood of a recession, there is no doubt about the fragile state of the economy. Yet even after a year of declines, many stocks are not properly discounted for that fragility, in our view. That said, we remain alert to opportunities that may well emerge as the economic picture continues to develop.

After decades of loose monetary policy, the Federal Reserve Board has embarked on a mission to tighten credit by sharply raising interest rates. This change has been forced on the Fed by rampant price inflation in everyday goods and services. Many critics of the Fed argue that decades of easy monetary policy (artificially suppressed interest rates) have buoyed asset prices, leading to greater wealth inequality. The Fed has also engaged in quantitative easing, which enabled large government deficits. We agree with the Fed’s critics that such policies went on for far too long and unleashed some of the economic ills being felt today.

Federal Reserve Board policy has provided the fuel for asset bubbles. Long-time Fed chairman Alan Greenspan presided over the meltdown in 2000 brought on by the dot.com mania. Ben Bernanke was Fed chairman when the housing bubble burst in 2007-2008, leading to the financial crisis and Great Recession. And now Jerome Powell is grappling with a market collapse brought on by the highest inflation in 40 years. Only Janet Yellen (chairwoman from 2014-2018) escaped the fallout from loose monetary policy. Using the tool of low interest rates to tamp down every little fire in the stock market has simply resulted in more dry tinder and eventually larger fires.

When inflation in food, energy, airfare, rent, and just about everything that affects daily life started to accelerate in 2021, the Fed attributed the price changes to transitory forces. They said the changes were caused by special factors related to the pandemic and would wind down as bottlenecks in supply chains abated and people returned to the workforce. About one year ago the forecast from the Fed and the futures market was for interest rates of approximately ¼ of one percent by December 2022. Since the Fed controls shorter-term interest rates, it seemed likely that its forecast would become its policy. But we now know that did not happen. Interest rates are more than ten times higher than the forecast of a year ago. The Fed did not want to change its forecast or policy and admit that it had been engaged in wishful thinking. But it has been forced to radically alter policy by inflation that was not transitory, that did not fade away or burn itself out. Instead, inflation has spread more broadly and become hotter, turning into a true inflation conflagration that has burned investors and torched the budgets of lower-income consumers.

Monetary policy and demographics can be viewed as the fuel and dry conditions that made for a combustible economic situation. Add in swirling geopolitical winds and the combination of
forces became even more potent. The conditions for an inflation spike that would force the Fed to abandon its zero-interest rate policy have been present for some time. In retrospect it was the pandemic and policies enacted in response to the pandemic that sparked the inflationary fire. A long fuse was lit when Jerome Powell said in late spring 2020 that the government, through fiscal stimulus (lots of checks in every mailbox) and the Federal Reserve, through monetary stimulus, were going to err on the side of overfilling any economic holes left by the pandemic. We remember thinking at the time that there could be negative repercussions from such aggressive policies, but the only effect for the next 18 months was a robust stock market. The negative implications of filling the economic forest with dry tinder took two years to manifest.

Over the past few months, it has been shocking to see the bond market, usually a paradigm of careful analysis, be so out of step with the change in Fed policy. Bond market investors seem to be in denial about a major shift in Fed policy, and the stock market which now slavishly responds to every up or down tick in bond prices is also in denial. The Fed has clearly lost credibility with investors, because of its repeated pronouncements in 2021 that inflation was transitory, requiring no need to raise interest rates. Investors who once closely followed Fed forecasts now see the central bank as incompetent and unpredictable. Investors are starting to ignore the old Wall Street adage that warns investors to “not fight the Fed.” Fed chairman Powell and numerous Fed governors have felt it necessary to remind investors that the Fed is not kidding; interest rates will keep rising and will stay high until inflation is squelched. A familiar pattern is emerging, of a plunge in financial markets after the warnings, followed by a subsequent rally that does not hold. Bond and stock prices are being reluctantly, slowly, painfully reset to levels that conform to the new regime of higher interest rates.

Current Strategy

The bear market of 2022 has been long and drawn out, unlike the bear market of 2020, which was over just weeks after it began. The difference is that this time the Fed has not rescued the market with extremely low interest rates. Instead, almost every asset class is being pulled down by the gravity exerted by high and rising rates. Over the past thirty years when stocks fell into a correction or bear market, other asset classes such as bonds and gold would often gain value. That’s not happening now. There are few, if any, places to fully preserve capital other than cash. Even bonds bought a few weeks ago at yields of nearly four percent have lost a bit of value as inflation numbers remain elevated and interest rates keep climbing.

The pressure on asset prices will not go away until interest rates stop climbing. This reality has not stopped investors from trying to time a bottom in stock prices. A hallmark of bear markets is large, sharp rallies that fade quickly. So far in 2022 there have been 38 trading days where the broad market indices gained or lost more than two percent; in all of 2021 there were only 8 such days. Bear markets rallies can be seductive, offering a salve to wounded accounts. But unless one can tell whether the rally will last for mere hours, a day or two, or maybe several weeks, they can be an invitation for further losses rather than gains.

We have tried to preserve capital by taking profits on our biggest winners from the 2020-2021 period, exiting almost all consumer staples companies and utilities at near record highs, and taking some modest losses on stocks bought late in the bull market cycle. When compared to current prices these sales were generally well-timed and helped preserve client capital. Despite all these protective sales, the remaining, much smaller list of holdings has declined more than we anticipated. Which is another way of saying that we should have “cleared the decks” by selling even more holdings back in 2021 when prices were higher. With stock prices now at much lower levels, the advantage in selling more holdings becomes less. There is less downside to protect from and less money coming in from a sale. Our focus has shifted to finding new positions to lift the equity exposure level of accounts to a similar or higher level than at the start of 2022. It is strategically imperative to have more exposure to equities on the way up than one had on the way down.

For the first time in at least fifteen years the bond market has become dynamic, a daily drama full of risk and reward. The Fed can no longer suppress bond rates as it has done for decades, so the word “reward” can be used again in relation to bonds. There is much to ponder concerning the peak, or terminal, interest rate. Everyone is trying to guess that number: is it 4, 5, or maybe even 6 percent? The eventual bottom in stock and bond prices, gold prices, real estate, and foreign currencies all hinge on that terminal rate. The situation is further complicated by the probability that intermediate-term interest rates could start to fall even as the shortest-term rates rise a bit more. This is called an interest rate inversion and is a common occurrence prior to recessions.

Trying to guess all the different peaks for various bond maturities is impossible. Our goal for clients is to build a laddered portfolio of bonds that spans from 2 to about 6 years, with a bit of longer dated (7-10 year) paper for certain accounts. Rather than making one big guess about interest rates, the laddered bond strategy allows us to make a series of judgements about rates as economic data is reported.

When Covid-19 crippled the U.S. economy last spring, it elicited an overwhelming government response. Government leaders stated their intention to backfill any economic hole created by the pandemic. They have certainly done that, pouring money into the pockets of both individuals and corporations through stimulus checks, payroll protection grants, enhanced unemployment payments, and child credits. Hundreds of billions in support has also flowed to states, cities, colleges, and medical institutions. The total amount of government aid in the U.S. has been over $5 trillion dollars.

This money, combined with low interest rates, has led to an explosion in asset prices. Real estate has been hot in many regions, stock indices are reaching new highs, and crypto currencies have raced ahead of all other assets. The economic hole has been more than filled and the excess liquidity is flooding into nearly all assets. But the biggest recent gains are in crypto currencies. At least some of the money from stimulus checks, it seems, is finding its way into bitcoin, ethereum, dogecoin, or some of the other 7,500 digital tokens on the market.

The digital token (crypto) world is not something we have addressed in the past. It is an esoteric and lightly-regulated asset. John Oliver, host of “Last Week Tonight,” put it best when he said that cryptocurrency and blockchain are “everything you don’t understand about money, combined with everything you don’t understand about computers.” Today, blockchain technology is increasingly embedded in newfangled assets, and cryptocurrencies have swelled to a collective valuation of over $2 trillion. Inventors and promoters of cryptocurrencies and blockchain technology want to supplant the financial world as it exists today, the one where the Federal Government, banks, and intermediaries such as Visa, Mastercard, and Paypal are the ones who issue currency, offer credit, and record and verify all financial transactions.

The idea of an alternative financial system that is heavily encrypted, anonymous, yet totally verifiable (as to the proper allocation of every debit or credit from a transaction) has appeal to people on the left and right of the political spectrum. Such a system is a check on the power of government to control money supply, track transactions, and levy taxes. No wonder the first question on every individual tax form, right under one’s name and address, now says: “At any time during 2020, did you receive, sell, send, exchange, or otherwise acquire any financial interest in any virtual currency?” Millions of Americans have made transactions in virtual currencies, but only a relative handful are responding with an honest answer to that question.

We are addressing the cryptocurrency craze now because it is the latest example of a speculative fever that has been sweeping the financial markets since last summer. A few months ago, all attention was on the meme stocks, such as Gamestop. As that fever subsided it was immediately replaced by dozens of cryptocurrencies that suddenly doubled or more in a matter of weeks. The biggest percentage gainer of all was something called Dogecoin, which was started as a joke back in 2013 by two computer software fellows who wanted to prove that foolish people would buy anything that purported to be a digital token. At the time there was a picture of a dog, a Shibu Inu breed, with a goofy look on its face that people found humorous and were exchanging with each other online. Dogecoin’s founders used that image as their mascot of sorts, hence the name Dogecoin. This digital “joke” coin sat for years at virtually no value, until the last few weeks when it shot to 45 cents per token, giving the 130 billion tokens a total value of $54 billion. This is truly speculation, and the greater fool theory in play at an extreme. It indicates how much money is floating around, and how impetuous people are willing to be in their speculation.

The sudden rise of cryptocurrencies, to a combined value of more than $2 trillion dollars, may in fact have dampened the rise in the stock market. Much of the wild speculation that used to occur in lower quality stocks near the end of bull markets has now moved over to the crypto markets, because the gains there can be lightning fast. The idea of investing in stocks, owning part of a company, and possibly benefitting from stock appreciation or dividends seems pedestrian compared to a double in a week (or a day) on a cryptocurrency. While the explosive public interest in cryptocurrencies may be a sign of a larger investment bubble about to pop, it could also mean that bubbles are occurring in different assets at different times, and are not intertwined with the broader investment universe.

Current Strategy

Excess liquidity has led to a series of rolling bubbles in various financial assets. While it is important to proceed with caution in such a pumped-up environment, there are still many companies with share prices that remain tethered to business fundamentals. The overall stock market has performed well in recent months, as investors rotated from elevated tech stocks to a broader list that included banks, industrial, retail, and consumer products companies. Watching investment bubbles expand and then pop can be fascinating, but should not distract investors from establishing worthwhile, long-term positions in companies that may be attractively valued. We have been active in this regard, capturing some of the dramatic gains made last year and redeploying those funds to companies that may benefit from a full economic reopening.

The bond market has begun to shift more significantly in 2021. As investors anticipate continued government spending, increased deficits, and potentially higher inflation, they have sold their longer-dated bonds. Short-term yields are still anchored in place by the policy and language of the Federal Reserve, but yields rose on 10- and 30-year bonds in recent months. We have begun buying corporate bonds for the first time in nearly a year, and will continue to add to our bond holdings if rates climb higher still.

Against a backdrop of dour headlines, the stock market rallied through the second quarter. It is hard to recall a time when enthusiasm reflected in the stock market contrasted so sharply with news about the economy and the state of the country. Fear turned to optimism, and in some sectors outright euphoria, in a matter of months. An alarming number of current investment anecdotes recall the spring of 2000 and the technology investment bubble. What started as fairly rational buying of the largest tech names has morphed into rampant speculation in companies that mirror or mimic the leading tech companies. Some of the hottest stocks in the current market were not even publicly traded last year, have never produced a product, and perhaps never will.

To better explain the performance of the major market indices, we can divide the stock market, and the economy overall, in two. Companies perceived to be “new economy,” technology-driven enterprises are strongly in favor with investors. Most others, thousands of companies that represent much of the U.S. economy, are either falling in value or gaining very little. Through the second week of July, the Russell 2000 Index, a list of 2000 smaller to medium size companies that typify the U.S. economy, was down 14% on the year. This is not surprising, given that the country is suffering through a recession with tens of millions unemployed. On the other hand, the NASDAQ 100, a much smaller selection of predominantly technology companies, was up 25% on the year. This is in part because its member companies are designed for a stay-at-home and work-at-home world.

The dichotomy in the market has reached extreme proportions. Amazon’s valuation has grown to $1.6 trillion, and is now larger than all other publicly-traded retailers in the country combined (a list that includes Walmart, Target, Best Buy, and dozens of other retailers). While Amazon is thought of as a technology company, the others are seen as simply retailers. Another example is Tesla, which is estimated to produce one half of one percent of cars globally, yet is now the most highly valued car company in the world. Its valuation exceeds the combined value of GM, Ford, Honda, Subaru, VW, Nissan, BMW, and Mercedes. Investors have decided that Tesla is in the “new economy” tech group, while all other auto companies are simply boring auto makers. We admire the technology that has gone into producing Tesla cars, the best electric cars on the market. But we do take issue with the valuation of Tesla stock, which seems to know no bounds. Elon Musk himself said that Tesla stock was overvalued at $750 per share, but that has not stopped traders from pushing the stock to twice that price.

Amazon and Tesla are examples of substantive companies whose valuations have potentially reached an extreme point. Below their ranks are many companies whose shares exhibit an even greater degree of euphoria. Nikola, a company with only a prototype and a stock that began trading in June, reminded investors enough of Tesla that its shares doubled in a few weeks. Another company, Tiziana Life Sciences, has seen its shares rise nearly 600% since March. In the absence of significant news, one might speculate that the reason for this climb is the fortunate ticker symbol TLSA, which is quite similar to Tesla’s TSLA. Perhaps some traders are just entering the wrong symbol in their haste to buy Tesla.

Investors who were fearful just a few months ago have decided to vastly increase risky stock market bets. There is one simple cause that is most likely at the root of the buying. In an attempt to bolster the economy, the U.S. Government and the Federal Reserve have injected massive amounts of money into the financial system. The money supply in the United States has grown by $3 trillion in just two months. Any stimulus that is not spent becomes savings, and savings in turn become investments of one form or another, whether deposited at a local bank or used to day-trade in the stock market. In a twisted irony, the complete bungling of the Covid-19 pandemic response in the U.S. has led to an increased need for massive financial stimulus, which in turn has fueled the stock market rebound. Pushed into a corner by near-zero interest rates and a recession that is crippling many businesses, investors decided the biggest tech stocks were the safest haven for funds. It was a reasonable idea, and through April and May it was one that we shared. However, good investment ideas can quickly become crowded trades, with many investors piling into the same small number of companies. And with too many investors pursuing the same stocks, these good ideas ultimately turn into dangerous investment holdings.

Current Strategy

Many of our share purchases in the second quarter consisted of technology and consumer staples companies. In both cases we sought to invest in companies we thought would be relatively immune or insulated from the effects of a more lasting economic shutdown. We also selectively sold shares in companies we thought would have more pronounced difficulties in a recession. Given the spate of economic problems companies are facing, however, and how stretched valuations have become on technology companies, we think it is important to remain cautious. While negligible yields make it wholly unrewarding to sit on any cash, we believe that is the correct thing to do in this market. We are shifting our focus from pursuing potential gains in a low stock market to preserving gains in a market that feels elevated.

The corporate bond market collapsed in March, alongside most other asset classes. Since that point nearly all bonds have rallied ferociously, with investors emboldened by the full support of Central Banks around the world. Our existing bond holdings have rallied, and the corporate bonds we bought in the depths of the market decline in March have since risen in value. The problem now is that yields are negligible wherever one looks, and few bonds offer a rate of return that even exceeds inflation. The gyrations in March are a reminder that conditions can change unexpectedly. Rather than commit to long-term bonds with what we view as poor yields, we think it best to stay on the sidelines for now and wait for better opportunities.