The fact that the major indexes all finished the First Quarter of 2023 in positive territory (S&P 500: 7.47%, Nasdaq: 16.77%, Dow: 0.38%) masks what was another period of exceptional market volatility. Indeed, the Chicago Board of Exchange’s Volatility Index, a forward-looking measurement of investor uncertainty and fear, spiked from an early-January low of 18.95 (a level not seen since the Fall of 2021) to a mid-March high of 27. Seeking a safe haven, investors purchased the shares of well-capitalized technology firms such as Google, Apple, Microsoft, and Meta (Facebook). This ‘flight to quality’ drove the Communication Services and Information Technology sectors of the S&P 500 up 20.49% and 24.1%, respectively, during the quarter. In contrast, the Energy sector of the S&P 500, one of the best performing sectors of 2022, declined -4.67%.

Even in times of increased volatility, sector-level return dispersion of this magnitude (~25%) is strikingly uncharacteristic of the S&P 500. And yet, it characterizes the post-COVID investment environment. Consider the following data: for the 67 calendar quarters (16.75 years) between March 2003 and December 2019 (pre-COVID), the S&P 500 experienced quarterly sector-level return dispersion greater than 25% only 7 times – hence the saying, “in bear markets correlations go to 1.”

However, between January 2020 and March 2023, a mere 13 calendar quarters (3.25 years), the S&P 500 has already posted 7 quarters of sector-level return dispersion in excess of 25%.

There were two factors responsible for the increased volatility.  First, acting to subdue the inflationary environment of 2022, the Federal Reserve continued to increase its benchmark interest rate, the Fed Funds rate.  At both its February and March meetings the Federal Reserve increased interest rates by 0.25%, bringing the benchmark interest rate to 5% from its December 2021 low of 0.25%.  Importantly, the present interest rate tightening cycle marks the fastest and highest pace of Federal Reserve interest rate increases in over 40 years.

Which brings us to the second (and closely related) factor: Silicon Valley Bank. As you are likely aware, on Friday, March 10th, Silicon Valley Bank (SVB) collapsed.  According to the Federal Deposit Insurance Corporation (FDIC), as of 12/31/2022, SVB had $209 billion in assets and about $175 billion in deposits, making it the second-largest bank failure in U.S. history.  

To understand how SVB’s collapse is related to the Federal Reserve’s unprecedented increase in interest-rates, let us begin by noting that SVB, with 17 branches in California and Massachusetts, catered to technology start-ups, biotech start-ups, venture capital firms, and private equity firms. The company prided itself on banking “nearly half of 2022 U.S. venture-capital backed technology and life science companies.”  For sure, one of the company’s investor presentations from 2022 highlights the fact that they were involved with “44% of 2022 U.S. venture-backed technology and healthcare initial public offerings (IPOs).”  

Why is this important? Consider, for example, what happens when a venture-capital or private equity firm with a relationship with SVB sells one of their portfolio companies in an IPO.  Upon receipt of funds from the sale, the venture-capital firm will deposit the funds into their SVB bank deposit account.  Or, if the VC has an immediate funding opportunity with a new start-up company, then the proceeds from the sale of the old company will be given to the new start-up, typically on the condition that the new start-up company establishes a banking relationship with SVB.  So, in either case, the funds end up in an SVB deposit account.  And this is precisely what happened: in the two years between Q1 2020 and Q4 2021, SVB deposits grew from ~$25B to $125B!  In ordinary times, and like all banks, SVB would use these funds (deposits) to underwrite commercial and personal loans and, very importantly, to meet the deposit claims of their other clients.  But these were not ordinary times.  

Business activity in Silicon Valley began to slow towards the end of 2021.  The IPO market began to dry up and then ground to a halt mid-2022 when public technology-company valuations collapsed and large-tech firms announced employee lay-offs.  As a result, SVB found themselves with fewer and fewer lending opportunities in 2022.  To earn money on their (now enormous) deposit base, SVB began purchasing fixed income securities, most of which were long-term treasury bonds and long-term mortgage-backed securities, very safe stuff from an “ability to pay” perspective.  However, although these securities were safe, they were very sensitive to changes in interest rates.  And when interest rates rapidly increased (remember the chart from earlier?), SVB incurred massive unrealized losses on this fixed income portfolio.  By itself, these unrealized losses weren’t enough to sink the bank.  However, SVB was the bank for start-up companies, and start-up companies, at least the vast majority of them, are hideously unprofitable and need outside funds to stay in operation (read: they burn jaw-dropping amounts of cash).  It is worth noting here that ~40% of SVB’s deposit base was early-stage healthcare and technology companies!     

Perhaps the mosaic is coming together?  Deposit withdrawals from start-up companies (client cash burn) could not be met with new deposits which were the result of public/private company sales because this market had dried up.  To meet their clients' deposit claims, SVB was forced to realize the losses on the aforementioned fixed-income investments.  This came to a head on March 8th, when, in response to these losses, SVB announced a $2.25B capital raise to try and “reposition the balance sheet for [the] current rate environment.”  As the saying goes, it was ‘a day late and a dollar short.’  The capital raise failed, and with it, the 16th largest bank in the United States. 

This brings us to today.  The efforts of the FDIC, Treasury, and Federal Reserve have successfully mitigated contagion risk and a material loss of confidence in the U.S. banking system.  Going forward, it is reasonable for investors to expect more stringent lending standards at the community and regional banks as a result of the failure of Silicon Valley Bank. Tighter lending standards will have the follow-on effect of slower loan growth and in turn, this will negatively impact economic growth.  

Despite this, there are several reasons to remain positive: 

• By subduing economic growth, tightening credit conditions will help the Federal Reserve slow inflation, a material positive for stock prices.  In the words of Chairman Powell, “it doesn’t all have to come from rate hikes.”

• Perhaps too much bad news is priced into stocks: the S&P 500 trades at ~17.75x Forward Earnings, down considerably from its 2021 high of 28x and below its 10-year average of 18.5x.