The first quarter of 2023 started off the year with a slew of negative macro headlines concerning bank runs, Fed rate hikes, recession fears, and omnipresent inflation. Counteracting these noisy, negative headlines, US equity markets delivered strong positive first-quarter returns. This brief update provides context to the aforementioned macro concerns and further dissection of the drivers of return.
Cheap Money Tide Has Receded
The multi-year-long tide of cheap money that propped up thousands of bad business models, has unquestionably receded creating a target-rich environment for uncovering opportunities to invest in business models that can survive and thrive in this new economic environment. Not to mention from an active-versus-passive perspective, this makes the go-forward, multi-year period exceptionally compelling. Our careful study of how all of this is likely to unfold in publicly traded equities leaves us increasingly optimistic about our ability to exploit active management to find the best investment opportunities going forward.
A Tale of Two Markets, Cont.
While there is less risk to business models from tighter capital for large-cap companies, they have become more vulnerable to the narrowing of return participation in the broad market. Put simply, 98% of the year-to-date return in the S&P 500 was derived from its seven largest issuers. This caused the largest companies in the index to become pricier, valuation-wise, while the remaining majority got cheaper. As of March 31st, everyone outside of the S&P’s top 10 (494 issuers in total) averaged 13.2x forward earnings. Meanwhile, its top-10 traded at 30.6x. Combined, the two cohorts aggregated to an overall weighted average index P/E of 18.1x, a level many would consider a far cry from reflecting elevated risks of a recession. Historically, market recession conditions merit low-teens forward-P/Es. The big take-home here, ~98% of issuers (by count rather than index weight) are already priced at recession levels. As a result, the market’s valuation seems more robust than is actually the case due to the overly large impact on valuation by its largest companies, an impact that is well above historical levels (please see chart 1 in our full report).
Reinstating Bank Crisis Plumbing
Though things seemed bleak during the weekend following the collapse of Silicon Valley Bank and Signature Bank, banking infrastructure was brought back online relatively quickly. Prior to the global financial crisis in 2008, all of these processes had to be built from scratch, with the result that the market suffered a multi-quarter-long contagion effect from the government’s finger-in-dike approach to propping up critical financial infrastructure. However, the silver lining to that brink of disaster 15 years ago, banking confidence could be restored in 2023 over a weekend. Despite enduring the US’s second-largest bank failure ever with SIVB’s collapse, the FDIC projects to incur a net $3.3B loss which is roughly just 2.6% of the deposit insurance fund that props up a nation’s worth of insured deposits.
None of this is a declaration of being out of the woods, and we’re not here to debate the merits of making uninsured depositors whole. It’s also very possible that bank balance sheet duration risk (i.e. deposit funding having far shorter liquidity than the securities/loans that sit on the banks’ asset sheet) could very much morph into credit risk. Digital technology tools that allow depositors to hit the exits at any given institution simultaneously are a permanent issue that financial institutions will need to address in their risk analysis. We expect a softening job market and further economic erosion to translate into higher delinquencies and ultimately charge-offs across various pockets of consumer credit. However, it’s more likely that we will be able to contain the situation far better than what led to 507 bank failures over 2008-2014 or the ~1,000 lost during the 1980s Savings & Loan crisis. Thanks to a decade plus period where regulators forced our banks to stockpile retained earnings onto the equity side of their balance sheets, today’s banks are on far better structural footing to absorb delinquencies that result in charge-offs. US banking regulatory Tier 1 capital ratios averaged 13.4% at the end of 2022, versus sub-10% in 2008. Plus, a March 2023 CPI headline print that marked its lowest since May 2021 is a good indication that pain alleviation should be delivered by Fed rate hike pauses this year.
AI: Hype or Step-Function?
2023 has provided a critical glimpse into our economic output through the lens of artificial intelligence’s impact on labor force productivity. The technical experts closest to the core of innovations in machine learning known as large language models (deep learning algorithms that process and understand language) describe this era of AI as our modern “iPhone moment.” However, truly disruptive opportunities in AI will likely stem from its various applications rather than one particular large language model that will rule them all.
The “AI heard around the world” via ChatGPT represents a salient plot point for a map of the current capabilities of the technology. We only have to go back to 2012 to see how AlexNet was able to destroy its competition by correctly identifying 85% of randomly selected cat images as true positives. About a decade later, plain English text input from a user with zero software coding experience can instruct AI to render a photo-realistic image of a cat wearing a tuxedo, in the aesthetic of a van Gogh painting. Current criticism targeting the narrow utility of this particular use case reminds us of those who laughed at the idea of selling paperback and hardcover books online in the late-90s; or those who dismissed how meaningful excess server capacity could become; today both ventures known as Amazon.com and Amazon AWS make these criticisms seem ridiculous in hindsight.
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Investment advisory services are offered through SWS Partners, LLC (“SWS”). SWS is an investment adviser registered with the Securities & Exchange Commission. Registration as an investment adviser does not imply any particular level of skill or training. All opinions and views mentioned in this report constitute our judgments of the date of writing and our opinions are subject to change at any time. We will not advise you as to any changes in figures or views found in this report in the future. Investing involves risk of loss and the investment return and principal value of portfolios under our management will fluctuate as the stock and bond markets fluctuate. Past performance is not indicative of future results.