How the Shiny Ball Bounced from Crypto, to Tech, to the Banks who Loved Them

Last week, there was an FDIC insured Certificate of Deposit offered yielding 13.8% and maturing in just 2 short weeks, while other banks were paying substantially lower for the same term. If it sounds too good to be true, it likely is. Investors get paid to take risk, so it was no surprise when the next morning that issuer, Silvergate Bank, announced a voluntary wind-down of operations and liquidation of the firm. Silicon Valley Bank, which lends primarily to start-up technology companies, was taken over by the FDIC yesterday. How can a bank such as Silicon Valley with over $200 billion in deposits fail?

When the economy is a bit too hot, the Federal Reserve increases short-term interest rates to gradually cool things off. Just a year ago, short term rates hovered above zero. During March of last year, the Federal Reserve initiated a series of increases to the Fed Funds Rate, which is the rate banks charge each other for overnight lending to meet reserve requirements. Today, after a series of the most dramatic increases ever seen, that rate is 4.5%-4.75%. Rising interest rates favor banks in that they can charge more on loans they issue, however as rates rise, the value of the fixed income investments in their portfolios falls, which can pressure their balance sheets and hamper their ability to meet customer withdrawals. A rising interest rate environment will separate strong banks from the weak. As rising rates slow the economy, other sectors of the market are also differentiated and previously high-flying investments fall out of bed. These two banks show how intertwined risks can become.

The crumbling of FTX last year catalyzed the beginning of the fall of cryptocurrency, which was the canary in the coal mine for frothy, speculative investments. Silvergate Bank, based in La Jolla, California, was the posterchild of froth as they had very few retail customer deposits, and held deposits of speculative venture capital funded start-ups, unproven technology companies, and, of course, cryptocurrency. It also operated an exchange to convert cryptocurrency into dollars, the Silvergate Exchange Network, which was shut down a week ago. No surprise that the largest customers on their exchange included FTX and Alameda Research. Silvergate Bank was founded in 1988 with a focus on real estate lending, but over time got lured into the shiny-ball markets of cryptocurrency and hot new technology companies. Rising interest rates and tumbling crypto prices ultimately led to a classic run on the bank and forced Silvergate to sell bonds at losses to meet demands. The weakness of speculative investments in crypto and unprofitable nascent technology companies were intertwined for Silvergate, as their business was almost solely concentrated in these spaces, and led to their failure.

The Silvergate and Silicon Valley failures come as no surprise as their business models were not properly diversified and were heavily concentrated in speculative areas. The chart below shows that Silicon Valley Bank (SIVB) was an extreme outlier – the strongest banks are in the upper left corner, and the banks with the riskiest profiles are in the lower right corner. Last December, I sold shares of Bank of America (BAC) from the Pawleys Dividend Fund, and added to shares of JP Morgan (JPM), as JPM has a lower risk-profile than BAC. Financial stability becomes increasingly important as the economy slows. This holds true for all sectors of the market, which is why I avoid frothy investments and focus on selecting stocks of companies with little or no debt, solid earnings growth, and rock-solid cash-flow. The historical performance numbers speak for themselves.

Sources: JP Morgan Asset Management, Silvergate Bank and SVB Financial (parent company of Silicon Valley Bank) Quarterly Filings.

A Different Super Bowl from Last Year

Last year, like in 2000, the commercials during the Super Bowl were dominated by the hottest current investment themes: Cryptocurrency and sexy new technology companies. Please see my post from last February addressing what a mistake it can be to put your hard earned dollars into unproven trends, often hyped by celebrity promoters who have little knowledge of complex investments (hint-hint: Tom, Gisele, and FTX). These high-flying “FOMO” (fear of missing out) ideas of the past abruptly stopped working last year, and many who had chased the shiny ideas of Crypto and NFTs incurred very significant losses.

This year, we won’t see commercials from potential high-flying investments, but from from more down to earth consumer companies. We will see, however, a cool all-female team of Navy high flyers soar over State Farm Stadium to celebrate the start of the game and 50 years of women pilots in the military. I too, have stood on the shoulders of women who were early to my industry. This week in Miami one of the biggest industry conferences was held, and there were several tributes to Kathleen Moriarty, who was a pioneer in the investment world, and instrumental in creating the first Exchange Traded Fund. Muriel Siebert was the first woman to hold a seat on the New York Stock Exchange, joining the 1,365 male members in 1967, the year I was born.

For decades, women have broken the sound barrier to enable me to soar in the investment world today. The Pawleys Dividend Fund and Pawleys Growth Fund have consistently outperformed the market, as we select stocks of companies with little or no debt, consistent earnings growth, and rock-solid cash-flow. There are numerous studies that show female fund managers perform better than their male counterparts, yet only a tiny fraction of funds are women-led. Women are still taxiing down the runway to gain more market share, and our soaring performance will get us there.

Are there Monsters Under the Bed?

The business headlines are covered with stories of last year’s sexy darlings tumbling out of bed. Crypto coins, miners and brokers have fallen as much as -80%, most SPAC’s (blank-check Special Purpose Acquisition Companies) are way below their initial offering prices, Chinese Internet stocks are down -70%, and the “meme” stocks like GameStop are off about -65%. Not to mention the outright false pricing and theft occurring with NFT’s (Non-Fungible Tokens) and digital properties in various Metaverse virtual reality worlds like Sandbox and Decentraland. When previously high-flying investments fall out of bed, it is an especially good time to make sure there are no surprises lurking in a portfolio. The Dow Jones Industrial Average and S&P 500 are down -9% and -14% for 2022 respectively, and the technology-focused NASDAQ has fallen consistently since last fall, so maintaining portfolio quality is critical as we move through 2022.

A good starting point is to evaluate the S&P 500 to see how stocks compare. Companies are facing rising interest rates and persistent inflationary pressures. There are actually 504 stocks in the index since there are four companies with two different share classes (Google, Fox, News Corp, and Under Armour). Companies are facing rising borrowing costs as the Federal Reserve raises interest rates and slows bond purchases, so debt:equity is a good ratio to review. Companies with excessive outstanding debt eventually have to pay off their loans, which becomes a drag on earnings. As of today, there are only 18 companies in the S&P 500 with zero debt, and there are a whopping 152 companies that owe more in debt that the total equity value of the company. Persistent inflationary pressure will challenge companies in delivering consistent earnings growth. There are only 90 companies in the S&P 500 with 5-year earning-per-share growth above +25%, and 183 are below +5%, with 19 that are negative. Out of 500 companies, wouldn’t it be better to choose financially sound companies with strong balance sheets and consistently growing earnings? Index funds are a great vehicle for those just starting to invest in the stock market. We use SPY, the S&P 500 ETF (Exchange Traded Fund) as a way to make tactical moves into the market at opportune times. But the core of the money we manage on behalf of clients is invested in concentrated portfolios of stocks with little or no debt, good earnings growth and rock-solid cash-flow.

There are many ways to construct portfolios and select stocks that deliver solid performance over time. In my opinion, and what has consistently worked well for both the Pawleys Dividend Fund and the Pawleys Growth Fund, is to balance sector weightings and choose stocks of companies with little or no debt, good earnings growth, and rock-solid cash flow. We don’t beat the markets every year, but the exceptional long-term numbers speak for themselves, and our clients can sleep well.

Source: yahoo! finance, Refinitiv