Bank Crisis: Worst Potential Outcome, Where To Put Your Money Now

“If something cannot go on forever it will stop._ Herbert Stein, economist

When the history of the current bank crisis is written, the majority view of future historians is likely to be that the underlying cause was easy money. It’s not a hard call because that’s always the underlying cause for Bubbles. Bubbles take place during good times in prosperous societies which are awash in cheap money. Cheap and abundant money pushes assets up to absurd prices. Who doesn’t like that – at least until the Bubble blows up.

Sometimes the assets which go up in a Bubble are perfectly good, or would be at the right price. Examples are consumer staples companies which were fine until they became TINA (There Is No Alternative) stocks popular for their dividends. I wrote a piece on a few of these stocks a couple of years ago, focusing on McDonald’s (MCD) and Coca-Cola (KO) and saying that they are OK as businesses but would soon use up their runway for raising dividends. I also noted that if rates ever increased they would have problems rolling over debt at rates which sustained their use of debt for dividend growth and buybacks which provided the bulk of earnings growth. I added that they were greatly overpriced between 25 and 30 times earnings. That article riled up more commenters than any other article I have published. Commenters wrote as if I were trying to take away something they felt entitled to. Reaching for yield is a consequence of easy money.

The valuations which evolved over the past 15 years were much more extreme among the established tech-oriented growth stocks. In their case what I considered absurd valuations might have been at least debatable if they came with an assurance that money would be available forever at near-zero interest rates. The half dozen or so most successful tech innovators grew into mega caps over the decade of cheap money and pulled up the S&P 500 Index (VOO) to major overvaluation. At one point the top 10 stocks in the index made up more than more than 30% of its total market cap. In 2020, the last tremendous year for the S&P 500, the top 5 stocks provided 37% of the gains.

These stocks began to decline steadily starting in November 2021 mainly because they were overvalued but also because they had expanded frivolously during the era of cheap money. Here’s a chart showing how the Invesco QQQ ETF (serving as the proxy for tech-oriented high growth) pulled up the Vanguard S&P 500 ETF (VOO) over the period of hyper-low rates up until November of 2021:

Neither tech growth stocks nor consumer staples were the stocks that popped the Bubble, however. That dubious distinction belongs to Crypto and tech-oriented start-ups.

Stability Leads To Instability

You have probably heard the name Hyman Minsky a few times in the past two weeks of crisis. Minsky, who died in 1994, extended the work of his doctoral advisors Joseph Schumpeter and Wassily Leontief, and put forward the thesis that an extended period of prosperous stability inevitably leads to wild speculation and ultimately to instability. The term “Minsky Moment” refers to the moment when speculation has gone as far as it can go and the Bubble comes apart. Banks were the epicenter of the current crisis but Crypto and Venture Capital along with a few similar or related assets marked the turning point where the Bubble started to unravel.

Normal cost of capital holds down risky assets to a handful with the best prospects, but rates have not been normal since the Fed began to suppress rates in response to the Great Financial Crisis of 2007-2009. For most of that period Quantitative Easing (QE) held rates close to zero for most maturities. Both the great tech/media companies such as Amazon (AMZN), Alphabet (GOOG)(GOOGL), and Meta (META) and other major innovators such as Tesla (TSLA) and Netflix (NFLX) went through their start-up phases in the earlier period of more normal rates while you are pressed to think of similar successes in recent years. There’s Uber (UBER) maybe, although the low rate environment made it uninterested in making profits until recently.

The purest example of the rise in dubious “assets” is Crypto Currencies. which have yet to reveal any practical use which might produce earnings and cash flow or show a price stability which could make it useful as a currency. In an era of cheap and abundant money, however, it struck many investors, including a few smart ones, as worth taking a flyer. Stocks and bonds were returning less and less with each passing year. Why not take a flyer with Bitcoin?

The first chart below shows how perfectly Crypto fit the era of hyper low rates from the Great Financial Crisis to last year. It’s important to note that Bitcoin was worth exactly the same amount at every point on the chart. It had no quarterly earnings reports because it had no earnings. It was obviously too volatile to serve as a currency. What changed from day to day and year to year was the way buyers and sellers felt about it.

The second chart (the Federal Funds rate) shows how the Fed stepped on rates with a couple of minor exceptions throughout the period following the GFC. A brief effort to normalize rates which started gently in 2016 and steepened in 2018 was led to a 19% drop in stock the 4th quarter of 2018 and the Fed was in the process of pulling its rate increases back when the arrival of COVID led it to drop rates to zero again, expand monetary easing again, and enlist fiscal expansionism by the administration and Congress. A market decline over the period after the GFC came to be described as a “Taper Tantrum.” The Fed responded in a way that let things get out of control.

Part of the rationale for Crypto was its supposed independence and universal availability without the need for intermediation by national banks or any other governmental authority. It turned out that it did very much need intermediation. Instead of responsible authorities operating within a framework of rules Crypto came to be held not by anarchic idealists but by scoundrels eager to take advantage of naive believers and, alas, a few unlucky banks.

Where Goeth Bitcoin, There Goeth Tech Start-Ups

Warren Buffett and Charlie Munger don’t and won’t own Bitcoin or any other Crypto currency. They also won’t touch start-ups, IPOs, SPACs, NFTs or companies that don’t have positive earnings and cash flows. Have you ever asked yourself why? The short and simple answer is that the probability of success with these “assets” is low. You are making a bet that resembles buying a lottery ticket and pretending that it is an investment. A lottery ticket is a small piece of paper which is likely to end up in your waste basket within a day or two.

Lest you think that Buffett, Munger, and the author of this article are just cranky old guys who don’t get it with phenomena like Crypto and tech start-ups, you should note that most bankers were equally uninterested in either Crypto or tech-oriented Venture Capital. (concentrated geographically in northern California). The large banks paid just enough lip service to Bitcoin to say to their shareholders that they were looking into it and had it covered while the tech start-ups were happily contained geographically in Northern California where they were somebody else’s problem.

Interest rates have different impacts on different types of companies. For companies with steady moderate growth, rates don’t really matter that much. Low and falling rates makes them more valuable, but earnings and cash flow are the things that really matter. Growth companies with sharply rising earnings and cash flow benefit much more from low and falling rates because the value of earnings and cash flow in the distant future if heavily discounted. That’s why Amazon (AMZN), for example, sells at a much higher P/E multiple than, for example, Berkshire Hathaway (BRK.A)(BRK.B). A good bit depends upon how likely those future earnings and cash flows are. Growth investors often overestimate the future growth of growth companies. Growth estimates are frequently too optimistic

Bitcoin holders, of course, have no worries about price to earnings or price to cash flow ratios because they have no earnings of cash flow. Bitcoin was in effect liberated from mundane concerns. It’s really like committing to buy a lottery ticket every day and ignoring the daily disappointments while waiting for the giant payoff which is pushed indefinitely into the future with no discounting factor. Why not cross your fingers and take a shot at it? That conforms pretty much to the mentality of Venture Capital which is a low probability investment with just enough occasional giant winner to keep entrepreneurs and their financials backers doing it.

Most VC projects burn through a lot of money and ultimately have no results. Only a few make it to the stage of being IPOs. In the best of times VC has a low enough percentage of winners that only a small number of entrepreneurial plungers. Banks like Silvergate Capital (SI) and Signature Bank (SBNY), both of which welcomed Bitcoin, must have looked at it as a means to diversify and extend their customer base. Some readers may recall that Signature has a history of concentrated positions in odd and funky assets including taxi medallions which they financed when other banks wouldn’t, only to watch their value driven down severely by Uber and Lyft (LYFT) resulting in a 74% quarterly earnings miss in 2014.

Recent start-ups have had a lower percentage of winners and must have lower quality than usual as evidenced by the absence of IPOs over the past year and the actual absence of huge winners over more than a decade. As stated in an earlier section, the great mega-caps of tech – Amazons, Apple, Meta (as Facebook), Netflix, and even Tesla – were founded before 2010, and most had gone public or did so early in the 2010s decade. In the last year there have been very few IPOs.

The disastrous decline in Series B funding levels – the important late stage funding before a start-up is ready for an IPO – suggests that something was wrong in the whole Venture Capital ecosystem apart from the other problems with Silicon Valley Bank. Either something was wrong in the system or, as I suspect, the quality of the start-ups was just not up to standard. It’s hard to find frank discussion this because venture capitalists are a tight group in San Francisco as anyone could see in their CNBC presentations during the collapse on March 10 with one advocate insisting that if they couldn’t meet payroll the following Monday innovation in the U.S. would be set back ten years. In fact, loans to cash burning start-ups with funds drawn from their pool of deposits might have eventually led to a crisis without any other factors.

The uncertain quality of pre-IPO start-ups is actually consistent with the track record of companies which made it through sometimes very successful and celebrated IPOs. The subsequent record of most of them is uninspiring to say the least. For those of you interested I refer you to this article on ARK Innovation ETF (ARKK) written just over a year ago It contains a conveniently visible list of ARKK holdings many of which were IPOs recent years. More than 60% had negative earnings and cash flows. There’s another list presented on the SA site in this article interviewing David Trainer who named a list of companies which he believed would never have positive earnings. There are several overlaps with the ARK Innovation list presented in my earlier article. Trainer, by the way, is in my opinion one of the incisive writers on this site.

In the ARKK article I noted how the value of the ETF went up slowly until 2020 and then began to crash in early 2021, ultimately losing over 80% of its value from high to low. The 2017 spike in ARKK was 87% derived from the spike in Grayscale Bitcoin Trust (OTC:GBTC) in the second half of 2017. The chart below compares ARK Innovation ETF and Grayscale.

What’s most interesting in the chart above is the correlation of Grayscale Bitcoin and the ARK Innovation portfolio of recent IPO graduates from the most recent cluster of tech startups. Both Crypto and start-up tech hit their peaks in February 15 and 18, 2021, just two days apart and exactly nine months before QQQ and its largest mega-cap members like Alphabet, Amazon, and Meta rolled over. You can think of them as the last grains of sand in the unstable sandpile which set the collapse in motion, validating the principle that the most dubious assets join a Bubble last and are the first to crack. Taking a step back one can make the argument that both the current crop of start-ups which played an immediate role in the bank crisis and many IPOs of recent years which haven’t succeeded were products of an era of easy money malinvestment.

The Worst Possible Outcome Of The Bank Crisis

We all wish the banks a speedy recovery, but it must not be achieved at the price of returning to the hyper low interest rates and abundance of easy money which went on for much of the past fifteen years. It leads to distortions in the stock and bond markets with spillover to the real economy. As implied above, the risk of massive malinvestment is huge. When money is cheap companies dump it into imprudent initiatives without clear goals and investors throw money at ridiculous companies and other assets which have no plausible rationale for their existence and should simply disappear into quiet oblivion.

This has nothing to do with the Fed’s responsibility to deal with inflation. if we locked the Fed members in a room and provided them with sandwiches and reading material, inflation would likely be down to 3% or so within two years. That’s low enough. That was the 100 year average when the famous Chen-Ibbotson study used it for the inflation factor in breaking down stock performance from 1926 to 2000 and there’s a strong argument that the two decades that followed and brought the average inflation rate down to a ten year average of 1.5% was an extreme outlier. Inflation that low may lead to higher stock prices, especially in growth stocks, but it is not a feature of a strong economy. The long term view has been that inflation up to 3% is the grease that lubricates economic growth.

What does normal look like? For stocks it looks like about 7% real growth plus 3% inflation added in with an equity risk premium around 5%. That’s an economy that grows smoothly and well. The average dividend rate should be around 4%. That’s almost half of average stock return, and shareholder return including buybacks should be, on average, at least that. The average quality bond yield should be a point or two higher than the shareholder return on equities. The P/E for an average stock, a stock with regular slow growth, should be about 15. A stock with very good and predictable growth could be as high as 25 or 30, and only an elite few deserve higher P/Es in their early years. Coca-Cola and McDonald’s do not fit that description. They are average. Period. Glance over those numbers again. They seem strange because we have not seen numbers like that for the past fifteen years. Have the underlying realities of financial markets changed that much? Only in one respect: extraordinarily low interest rates and a superabundance of money.

Taking a big step back toward more normal times as defined by the numbers above is the Fed’s real objective. A return to low rates enabling another long market trudge upward would serve only to pull future stock returns into the present. This puts conservative savers who use the financial markets to preserve value in the bad position of constantly reaching for yield and increasing risk. It also comes with the threat of a greater blow-up down the road.

As for inflation, I pledge to expand upon the view that it will continue to recede toward 3% in an I Bond article I plan to write in April when the March inflation numbers are in. Year over year and month over month inflation numbers are very different. Year over year numbers persist in making the headline number looks shockingly high. The month over month numbers show that actual present inflation is already not far from 3.25%. Needless to say we will not likely move back to the absolute price level that existed before inflation suddenly kicked up. The short version is that inflation peaked last June when then the year over year number was 9.1% and the month over that number was 1.37%. The average M/M rate for the last 8 months has been less than .2%. In July. when the peak M/M rate comes off the Y/Y list, the headline rate will drop like a rock. Prices are high right now and will remain high but the rate of inflation is rapidly slowing.

The irony is that the Fed projections were not exactly wrong. This bout of inflation is indeed likely to prove “transitory.” In its underlying causation it closely resembles the sudden jumps which followed both world wars. Inflation then declined with an actual year or two overshoot but prices never went back to their pre-war levels. The 1970s inflation was the final spike at the end of a fifty year cycle from the deflationary low in the Great Depression. A generation of consumers and businesses had known nothing in their lifetimes but prices which always go up and go up at an increasing rate. This inflation isn’t that inflation. The Fed had it basically right but was off about a year in the timing. Higher rates were necessary and the natural price tendency will take care of the rest. Falling back into the role of providing cheap money will only produce slow growth, malinvestment, and a revival of garbage assets which are priced for a future which will never arrive.

Some New Questions Before Buying Banks

It has been relatively easy in recent years to analyze banks. It’s a bit tedious, but there was a standard template that could be updated from time to time. I know this because over the past two years I have written a number of articles laying out the pros and cons of the six major banks. The list below contains the major facts and ratios that were necessary to evaluate banks in recent years:

• Understand the mix of businesses. Goldman Sachs (GS) is predominantly an investment bank, having failed miserably to establish a main street bank business. The absence of IPOs has crimped its earnings. Morgan Stanley (MS) is also an investment bank but has substantial wealth management and brokerage. JPMorgan (JPM) is fully diversified and has a large international presence while Bank of America ranks second in these categories and has the greatest Main Street Presence followed by Wells Fargo (WFC) and Citi (C).
• Analyze and make future estimates of NII (Net Interest Income) and NIM (Net Interest Mafgin).
• Track revenue and earnings growth and buybacks. Does the bank do as well by its shareholders as it does by its high level employees?
• Pay close attention to the results of stress tests.
• How sticky are its retails depositors?

Additional considerations that now figure importantly in evaluating banks include:

• How diversified is its depositor base and what percentage of its deposits are not backed by FDIC insurance?
• How diversified are loan customers and how committed is the bank to what BAC calls “Responsible Growth.”
• What does it have in its loan portfolio? How much commercial real estate?
• How large a portfolio of Treasury Bonds does it own which are now under water because of sharply increased interest rates?
• Read quarterly statements carefully and pay attention to results they wish to emphasize and subjects on which they evade questions or dodge expanding upon brief comments.

Don’t be deceived by the many articles saying that large banks are safe or Bank X is “too cheap to ignore” now that it is down 40%.” The large banks probably are safe, in part because of the stress tests and in part because they are literally too large for the financial authorities to let them fail. Don’t rush hastily into what looks like cold-blooded contrarian. Many negatives will hang over banks for a while, one of which is increased regulation which comes close to nationalizing the banking industry. Notice that shareholders come last when the authorities deal with a bank in trouble, certain bondholders too as happened in the Additional Tier 1 “convertibles” written to zero in the Credit Suisse example.

Things have changed. In the past Bank of America would have boasted to have deposits up $13 billion. In the past two weeks deposits were reported to have jumped by that amount and the question that popped instantly into my mind was Oh my God, what loans or bonds are they going to invest that $13 billion in? BAC is the bank I own, with a large capital gain embedded, but I haven’t been pleased with a number of their actions for a couple of years and about once a month wonder if I should sell and take the tax hit. I haven’t. Yet.

Where Should You Be Putting Your Money Now?

Thanks to the Fed the odds have shifted powerfully toward safety and fixed income. Over the past six months there have been periods in which you could buy super-safe US Treasuries at maturities out to 10 years with a yield well above 4%. The peak in the longer maturities was October 2022, although the longer maturities, after a decline, had bounced back to 4% just before the banking crisis broke. Although I had been buying Treasuries since last fall I made a quick decision on March 10, the day Silicon Valley Bank went under, and I decided that the bank problem likely meant that we had reached the peak in most rates and forced myself to buy a chunk more Treasuries at 5-year and slightly shorter maturities. The reason not to go longer had to do mainly with the fact that I am 78 years old.

For those of you who have looked wistfully back at a past when a 60-40 stock bond portfolio made sense, this is probably it! Even though the Fed raised rates by 25 basis points Treasuries at all but the shortest maturities have rallied and rates have declined suggesting that the market sensed that we have reached the peak. The current rates are still not bad for the fixed income side of a 60-40 portfolios compared to the returns I see as probable in stocks. Taking into account current valuations as measured by market price to earnings, price to books, price to sales, and price to free cash flow, market returns including dividends seem unlikely to return on average more than 4-5%. Totally safe fixed income remains a good deal.

There is also a way I used to boost the safe fixed side of my family portfolio’s more than 100 basis points compared to Treasuries. Sponsored CDs at major sites like Vanguard, which I use, are put in place at a particular price and stay at that price for a period of time. On March 20 and early last week I clicked on Vanguard bonds and CDs and poured over the CDs all of which are fully insured by the FDIC up to $250,000. Even though there is talk of raising that number, for now I urge you to observe that limit and thus spread your CDs out over a number of firms if necessary. The rates I got varied from 5.25% to 4.85% and pulled my total fixed portfolio up to a yield over 4.5%. I don’t know what rates are left, but I suggest taking a quick look. You are likely to find rates that will significantly exceed what is available in Treasuries at most maturities.

Avoid callable CDs. While you may have your own preference for maturities – and I think 5 years is a generally good idea – you don’t want your CD called away if rates decline sharply, which I think is reasonably likely. You could also use a ladder, possibly going out beyond 5 years, but I would start with maturities at three or four years. You would ideally like the 60-40 portfolio to have a chance to continue for a while. Cash, in fact, is not a bad option for the very short term with the Vanguard Federal Money Market Fund (VMFXX) offering 4.65% as of this mornings. If and when the Fed is done, it will decline.

This is not a program that will make you rich. It’s a way to survive with near 100% safety and wait for a time when better opportunities. CDs and Treasuries are wonderfully asymmetrical with zero risk and 4-5% return.

Be safe. Good investing.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.