The Margin of Safety Quarterly Spring 2023
A Look Ahead:
- Cash Management: Are You Leaving Returns on the Table?
- Investment Outlook & Portfolio Positioning
- Foreign Stocks: Valuations Attractive
- Life Insurance & Annuities: Deciphering the Sales Pitch
- Firm News & Closing Thoughts
Quarterly Investment Commentary First Quarter 2023
Despite the stress in the banking system, including the failure of Silicon Valley Bank, global equity markets held up remarkably well in March and posted solid returns for the quarter.
The S&P 500 index was up 3.7% in March and gained 7.5% in the first quarter. Developed international stocks (MSCI EAFE Index) did a bit better, rising 8.5% for the quarter (and returning 2.5% in March). Emerging markets stocks (MSCI EM Index) gained 4% for the quarter and rose 3% in March. This would be hard to tell from the financial press which mostly reported bad news for the full quarter. We think that the results of this quarter showcase why we do not believe that trying to time the market works and why following the investment advice received through the press is harmful to your financial health.
Although in general the market returns were positive for the quarter there was some substantial shift in what worked. Where the fact that international stocks increased at a faster clip than U.S. stocks helped our portfolios, the fact that large-cap growth stocks (Russell 1000 Growth Index) gained 14.4% in the quarter, while the large-cap value stocks returned 1% (Russell 1000 Value Index) did not benefit our portfolios. The Nasdaq Composite Index surged 17%, while the Russell 2000 Small Cap Value Index dropped 0.7%. We will discuss further later why we do not believe that this will continue through the year.
Fixed-income markets had a strong quarter as longer-term bond yields fell, generating price gains. Core investment-grade bonds (Bloomberg U.S. Aggregate Bond Index) returned 3%, as the 10-year Treasury yield fell to 3.5% from 3.9% at year-end. Riskier high-yield bonds (ICE BofA U.S. High Yield Index) outperformed core bonds gaining 3.7%. Municipal bonds gained 2.3% (Morningstar National Muni Bond Category). Flexible/nontraditional bond funds gained around 3%.
Alternative strategies and nontraditional asset classes generally underperformed traditional stock and bond indexes for the quarter. Trend-following managed futures strategies had a particularly tough period, losing anywhere from 6% to 10%, as some of the major trends from 2022 sharply reversed – particularly interest rates.
Quick Recap: The Silicon Valley Bank Failure
What happened and why it is not the beginning of another financial crisis.
By now, the story of the Silicon Valley Bank (SVB) failure is well known. But we think a quick recap is worthwhile as it provides context for our investment outlook and portfolio positioning that follows.
In a nutshell, Silicon Valley Bank was the victim of a classic “bank run” – too many depositors wanted their money back simultaneously and SVB didn’t have the cash on hand to meet customer withdrawals.
Importantly, SVB had unique characteristics that made it particularly susceptible to such a run that don’t necessarily apply to the broader banking industry, or at least to the same degree. This is one reason we do not see the failure of SVB as the beginning of a replay of the Great Financial Crisis (GFC) of 2008. But there clearly will be broader economic and financial market impacts.
SVB was particularly exposed to interest-rate risk as it held an unusually large share of its assets in long-duration bonds. As such, SVB faced extremely large unrealized losses on their bond portfolio when rates rose sharply last year as the Fed sought to choke off inflation. Moreover, unlike most banks with a diversified deposit base that includes individuals of all sizes and businesses in different sectors, SVB’s depositor base was comprised of start-up technology, venture capital firms and the like; and almost its entire depositor base was above the FDIC insurance limit of $250,000 per account.
Combined, these characteristics of SVB caused some of their concentrated, large, uninsured depositors to start pulling their money from the bank. This forced SVB to raise capital (liquidity) to meet the withdrawals by selling bonds at losses, turning the unrealized losses on their balance sheet into realized losses, raising the question of not only liquidity risk for the bank but solvency/bankruptcy risk, leading to even more depositor flight, etc. Ultimately, the FDIC and Fed stepped in over the weekend of March 11 to take over the bank, guarantee all SVB deposits above $250,000, and set up a broad banking system liquidity backstop (the Bank Term Funding Program (BTFP)). The BTFP allows banks to borrow from the Fed for up to a year, based on the issued face value (par value) of their treasury and agency MBS bonds, rather than the current (lower) market value. This new facility enables banks to meet deposit withdrawals and other liquidity needs without having to sell currently underwater bonds at a loss.
While the banking system is not out of the woods and there may be more small-bank takeovers, it seems these steps and subsequent actions from authorities have stemmed the risk of a widespread bank-run contagion.
Are you leaving returns on the table?
After SVB’s failure, we have been asked our thoughts on what clients should do with their emergency cash. If you have under $250,000 with any bank, we believe that you are strongly protected with FDIC insurance. If you have over $250,000 then you probably should at least be somewhat familiar with your bank’s financial situation.
Something that many people may not be aware of is how good certificate of deposit (CD) and money market rates are at the current moment. Many banks are still paying small amounts of interest on savings, checking, and, even in some cases, CDs and money markets. So, shopping around is key. We shared a blog post on this issue a couple of months ago but to summarize it here, we can currently get rates of around 5% on CDs of various maturities (note: available interest rates are subject to change).
We can further enhance cash management by building a ladder of CDs to hold various maturities depending on someone’s amount of cash reserves and needs. Additional benefits include purchasing the CDs in one single brokerage account providing you consolidation, the ability to structure the ladder to be under the FDIC limits per bank, and having the ability with purchased CDs to sell the CD prior to maturity without an interest penalty if you need to access cash quickly (note: the value of purchased CDs could be lower or higher than the original principal if you sell early). We offer this cash management service at a lower cost for our clients and in general the net return would be competitive with what can be obtained individually. We can also purchase government agency bonds that have interest rates of over 5% with maturities up to about five years. Government agency bonds have an implicit government guarantee, although one that has not been tested. We feel that these are nearly as safe as CDs.
If you want to construct a CD ladder on your own, websites like Bankrate and NerdWallet provide information on which banks are offering the highest rates. Shopping around is key though; as of April 13, 2023, Bank of America is only providing .05% on 10-month CDs and Community First is providing rates of around 4.2% on 12-month CDs. If you don’t actively manage your emergency cash, chances are you could be missing out on a lot of income.
Investment Outlook & Portfolio Positioning
We always consider a range of macroeconomic scenarios when constructing our investment views and diversified portfolios. Our approach is particularly valuable during periods of heightened uncertainty, which we would argue is the case today given the dynamics of inflation, Fed policy, and stress in the banking system.
On the inflation front, while inflation likely peaked last year and has come down, it remains too high relative to the Fed’s 2% long-term target. February’s year-over-year core CPI inflation rate was 5.5%, while core CPE inflation – the Fed’s preferred measure – clocked in at 4.6%.
Given persistently high inflation, the Fed has continued its rate hiking campaign this year, although the magnitude of rate hikes has diminished. At its March 22 FOMC meeting, the Fed hiked its federal funds policy rate by 25 basis points (0.25%) to a range of 4.75% to 5.0%. This was the Fed’s ninth consecutive hike since March 2022, representing a total tightening of 475bps (4.75 percentage points). This is the most aggressive monetary policy tightening campaign since the Paul Volcker days in the early 1980s. It was inevitable something (in this case SVB and other poorly managed banks) would “break” given the magnitude and speed of the hikes.
The Fed is still hoping they can land the economy softly without causing much more damage, let alone a recession. It’s not impossible, but the odds are low, and history is not on their side given the complexity of the task and the multitude of economic and behavioral variables outside of their control.
With above-normal inflation and the Fed sharply tightening, the short-term outlook for economic growth was already poor coming into the year. Add to that the negative impact from tighter credit conditions due to the recent banking stress, and the growth outlook has gotten worse. How much worse isn’t clear. But it hasn’t improved the chance of avoiding a recession this year.
However, all is not gloom and doom for the economy. Household and business balance sheets remain healthy and supportive of continued spending. U.S. households are still sitting on an estimated $1.4 trillion in pandemic-era savings. Employment remains robust, with a stronger than expected 311,000 new jobs in February, following the shockingly strong 504,000 jump in January. Real disposable income is rising as wage growth is now stronger than CPI inflation. Moreover, the U.S. and other major global economies appear to have grown in the first quarter of the year. So even if a recession does play out, these are all reasons to believe it may be relatively mild.
In an economic recession, it is almost certain corporate earnings will decline. S&P 500 index earnings typically decline around 15% to 20% (peak-to-trough) during economic recessions as both sales growth and profit margins compress. In a mild recession, the earnings decline might be closer to 10% to 15%. Yet, the current consensus earnings expectations for 2023 do not reflect nearly that magnitude of decline; nor do current stock market valuations. If our base case earnings recession scenario plays out, there is a strong likelihood that the S&P 500 index will materially decline from current levels. This is why we continue to overweight value stocks versus growth stocks.
Longer term, our current base case five-year expected return estimates for equities is for mid-single digit annualized returns over the period, which assumes a recessionary bear market happens. This is a decent but not great expected return for U.S. stocks given their risks. It is also well below our five-year return expectations for developed international and emerging markets (EM) equities of high single to low double-digit annual average returns.
Valuations for Foreign Stocks Attractive
Among the three regions of the U.S., international, and EM, we tactically favor EM stocks right now based on their higher expected returns, which are a function of what we expect will be faster sales growth and improving profit margins over the next several years. This comes after more than 10 years of stagnant EM earnings growth. We also expect some narrowing of the historically large valuation discount between EM and US indexes.
Finally, we expect the U.S. dollar to decline versus most other currencies over the medium-term, which would further add to EM and international equity returns for dollar-based (unhedged) investors. When the U.S. stock market declines to levels that offer more compelling medium-term returns and adequately discount shorter-term risks, we will look to add back exposure by selling more-defensive assets (bonds).
In addition to our core bond exposure, we continue to have a meaningful allocation to higher yielding, actively managed, flexible bond funds run by experienced teams with broad investment opportunity sets. There are many fixed-income sectors outside of traditional core bonds that offer attractive risk-return potential, and we want to access them via our active managers.
Something else that we have been doing for clients with lower liquidity needs who also meet certain regulatory requirements is diversifying into private investments (we discussed this briefly in last quarter’s newsletter). This is a way to diversify away from U.S. public markets in a period when we foresee lower returns. Private investments like private equity, private credit, and private real estate have long been the domain of the ultra-wealthy, endowments, pension plans, and foundations. The average allocation to private investments for these groups has been over 20% of their portfolios for many years.
To this point there has been limited ways for ordinary investors to access these markets. However, several law changes have resulted in new products coming to market from some of the larger institutions in these areas that provide access to more individuals. Over time the public market has gotten smaller and private markets have increased in size. Returns have generally been favorable in the past for these asset classes and risk has generally been constrained.
Life Insurance and Annuities
Many of us have heard the sales pitch and it sounds too good to be true. Often it goes something like this: are you scared about losses in the stock market and want a safe investment that can produce returns of 5% or more and grow tax free? We often say that life insurance and annuities are often sold to people but rarely is someone looking for the contract at least in the way that the salesperson is portraying it.
First for life insurance, we are not against this product in all circumstances. We believe that it should be used mostly as a way of either providing estate liquidity or reducing the risks that come with premature death. These purposes can often be solved by policies that do not generate material cash values while a person is alive. However, when we look at the policies that are generally sold to people, we find that they are often the most expensive policies and generate larger cash values throughout life. Cash value sounds like a good thing but it is generated by the policy more premium than is needed to cover the cost of insurance and then investing the difference. Usually, when the return of the policy is analyzed, it is very low, in the range of 3%. For this reason, if someone tries to sell you life insurance as an “investment” the best reaction is to seek an independent, objective opinion. If you would like us to, we can analyze a proposed policy and look “under the hood” for you to see if this represents what you truly need. We can also refer you to insurance agencies that we trust, who work only with fee-only advisors to get you a policy that will be appropriate for your needs.
A similar point applies to annuities. Often, these contracts have a very complicated structure that is difficult to understand. The person buying the annuity wants safety and the guarantee of “no downside” touted by the agent sounds very attractive. To further sweeten the appeal, agents will often boast of “returns of 5% or more,” benefit “bonuses,” and more. However, many contract owners find that what they thought the contract did and what it does are two very different things. For example, what an agent will often describe as a guaranteed return is a guaranteed withdrawal rate that produces much less return than the consumer believed they were receiving. The SEC has issued alerts warning investors about various annuity contracts and how some of them aren’t what they may seem.
All annuities are not bad, and more are coming to market that do offer very attractive terms. We have access to annuities with reduced cost structures since we do not accept commissions. These could only be purchased through a fee-only advisor like us. There are some very good reasons to buy an annuity such as to protect against longevity risk, to provide credit protection, or to potentially increase returns versus fixed income.
The moral of the story is that if things sound too good to be true, they probably are. If someone is trying to sell you a complex product be sure to get all the details. For most of these areas we can help and provide you an honest objective opinion. We are here to be relied upon as a financial resource for you and your family.
We have continued to invest in our infrastructure, and we have rolled out new ways for clients and prospects to interact with us over the last quarter. This includes the ability to book meetings using Calendly, which allows you to see our availability in real time and reduces back-and-forth communication. We have also introduced a compliant text messaging ability since many of us are busy and find texting to be a more efficient means of communication. We are reviewing software that could make it much simpler for new or current clients to provide us with information needed for planning and onboarding. We are hopeful to have more to share on this front soon!
We are also pleased to announce that, Dana Carney has passed her CERTIFIED FINANCIAL PLANNER™ examination. She still needs a few more hours to satisfy her work requirement so she won’t be able to officially use the certification until the fall. However, the hard work of completing the educational requirements and passing the exam are now behind her. We are very excited for her.
Rob Simon has also now completed the coursework for his Master’s degree in financial planning. He should be receiving his diploma within the next few months. The Master’s program was very challenging but insightful. Rog gained a lot of knowledge in the areas of legacy planning and charitable giving. This has improved his skills in these areas. We believe that it is important to continue increasing knowledge and all professionals are required to do continuing education. We encourage everyone to get additional designations as we think that this increased knowledge can help us assist our clients in new ways.
We continue to believe that the most important thing when investing is to have a strong game plan and to stick with it. One of the items that we believe can help to reinforce your game plan in times like this is to have a financial plan that backs up your investment plan. We continue to stress that a financial plan is not something that should only be developed a few years before retirement but really something that you should have from when you start investing. The financial plan answers the questions of how much you should be saving or spending and whether you are still on track. Portfolio construction matters very little if withdrawals are too high for a portfolio to sustain them or if your savings level is not adequate for future goals. If you don’t have a financial plan yet we encourage you to work with us to develop one.