SVB informs clients "back to business" yet carnage in FRC bonds, CITI+CS CDS (blowout) and KRE banks down 20% = Monetary Policy is finally "biting" = Fed can take foot off the gas. Ex-FAANG, S&P 500 P/E 14.3X ('24E), not demanding.

Monetary Policy is finally “biting” = Fed can take foot off the gas

On Monday evening, the new CEO of Silicon Valley Bank (SVB) sent an email to clients informing them SVB “is open and conducting business as usual.” I mean anyone would be surprised given that SVB (formerly SIVB) just collapsed the Friday prior (3/10) after a bank run and a worrying weekend for bank clients (nationwide) about the safety of deposits.

• SVB is now operating under receivership as a “bridge bank” until the assets are sold/resolved
• a widely circulated memo signed by 14 venture capital firms urged their respective portfolio companies to resume business relations with SVB. (Missing are the 3 firms which triggered the bank run last week, Founders Fund, USV and Coatue Capital).
• It is almost as if VCs and SVB want a “do-over” and to resume operations as if the crisis had never happened at all.
• Unfortunately, for the equity markets, there are signs of lingering carnage and these “smoking ruins” are why we believe the Fed will move cautiously into the March FOMC meeting next week (3/22).
• First, Moody’s on Tuesday announced cut the outlook for US banking system to negative and S&P put many regional banks on negative watch. Rating agencies often come in after the crisis to downgrade credits, so this is just adding gasoline to a fire.
• Second, Regional Bank stocks are still lying in ashes and the KBW Regional Bank (KRX) index is down 20% in the past month and 44 members are down <15% in that timeframe. Hardly signs of a “do-over.”
• Third, stocks presumably away from the epicenter such as First Republic (FRC) are still down >50% and FRC bonds are still 10 points below their pre-crisis levels (~77), but have bounced from a distress-like 53.
• Fourth, SIB or “systematically important” banks like C1.29%  and CS have seen their CDS (credit default swaps) blow out to 2023 wides and in the case of CS, all-time wides. The markets remain nervous about contagion reaching the SIB.
• This is happening because the FDIC/Fed took action to protect depositors, but equity and bondholders of SI, SIVB and SBNY0.00%  were wiped out. So capital markets are understandably wary of banks.
• This should worry the Fed. While not “explicit” in its dual mandate, the Federal Reserve Act established the Fed to “provide the nation with a safer, more flexible and more stable monetary and financial system” (thanks MH of SF for this). Much of the problems for the banks stem from the aggressive Fed hikes which is hammering the banking industry’s securities portfolio while deposits are drained from dwindling savings, move to USTs and distrust of banks.
• The Fed hiking aggressively further is delivering even greater pain to the banks. Fed hikes are directly driving losses for banks which was $620b at end of 2022 and the Powell testimony last week likely pushed this to nearly $900b (as 2Y and 10Y yields surged). In other words, the Fed’s monetary policy is finally “biting” (they looked for lags) and thus, the Fed can take its foot off the gas.
• In fact, if Fed pauses, and yields fall, this will drive a recovery of some bond prices, helping to repair bank balance sheets. This is another argument for a pause. For these reasons, we expect Fed to either pause or do a mere +25bp, with 50%/50% odds.
• This is a dovish development. And would be good for the rest of the stock market. Unfortunately, Financials are still in a world of pain, but with the bulk of that pain already delivered.
• We believe inflation is becoming somewhat of a sideshow as the “credit contraction” generated by above, coupled with the shock to start-ups means hit to jobs market, means inflationary pressures are abating. Perhaps even stopped in its tracks. This will not show up in the official data for some time as CPI is lagged.
• We will likely see this show up in jobless claims (labor softens = no wage pressure) and in credit contraction (H8 weekly report by Fed). Both a major disinflationary impulses with known connections to credit events.

• Feb CPI came in “tame” today, with Feb core CPI MoM +0.45% somewhat higher than 0.41% last month. And the YoY slowed to 5.5% from 5.6% (Jan). But this rise is really housing (+0.30% of 0.45%) and travel (0.08%).
• Does Fed want to hike in response to “hot” housing (slowing) and travel versus hikes creating more problems for banks? Besides, ex-housing, Core CPI came in at ~2.0% annualized.
• The VIX is resuming its “contango” meaning the 1M VIX futures contract is no longer above the 4M VIX. That is a sign that the “stress” is passing. And also supported by the VIX settling down to 23 after surging to a capitulatory 31 yesterday.
• This means our view of the 8 week rally (end of April) towards S&P 500 4,250 remains intact. This also aligns with Mark Newton’s view that markets would begin to strengthen on 3/15.
• As for valuation, the S&P 500 P/E (’24E) ex-FAANG has dropped to 14.3X. This is a 7% earnings yield. The stock market is offering a staggering high level of earnings yield for the investor today.

The “do-over”

I think this is ironic. SVB and VCs both want to mend fences as if nothing happened. But a major financial crisis took place.

FED: Dual mandate, but the Fed charter is literally “financial stability”

For those who think Fed’s only job is interest rates or employment, they are forgetting what the Federal Reserve Act actually chartered. The Fed was created for financial stability:

• runs on banks is not financial stability
• thanks MH of SF for this

REGIONAL BANKS: Still in ruins

Regional banks are still down 20% from highs. Like at PACW which is down 52% still. And one can appreciate the damage to investor confidence. As we noted, the FDIC/Fed protected depositors but equity holders were wiped out.

And this ratings agency action is backwards looking to me. This should have been reflected last year due to the rapid hikes by Fed.

• banks are hurt by dual issues of dwindling deposits (see above) and falling value of their bond holdings
• Fed hikes are directly driving losses for banks which was $620b at end of 2022 and the Powell testimony last week likely pushed this to nearly $900b.

SMOKING RUINS IN BANK BONDS: FRC CITI CS

As shown below, FRC bonds have made a nice recovery over past day or two but not back to 77 pre-crisis. This is due to reasons cited earlier. But a recovery towards 77 means the stock could trade back towards its book value of $80 per share.

And both CITI and CS have seen CDS spreads explode.

CALENDAR: Key incoming data starting March 10

There is lot of incoming economic data this week (durable goods, housing, unit labor costs and ISM) but for the key inflation-related data, there is a bit of a dead spot until early March. As shown below, this really starts March 10th:

• 3/7 10 am ET Powell testifies SenateHawkish
• 3/8 10am ET Powell testifies House Neutral
• 3/8 10am ET JOLTS Job Openings (Jan)Semi-strong
• 3/8 2pm ET Fed releases Beige Book Soft
• 3/10 8:30am ET Feb employment report Soft
• 3/13 Feb NY Fed survey inflation exp. Soft
• 3/14 6am ET NFIB Feb small biz survey Soft

• 3/14 8:30am ET CPI Feb Tame
• 3/15 8:30am ET PPI Feb
• 3/17 10am ET U. Mich. March prelim 1-yr inflation
• 3/22 2pm ET March FOMC rate decision
• 3/31 8:30am ET PCE Feb

FEB CPI: Less bad is good

Feb core came inline with consensus at 0.45% (0.4% Street) but it was an improvement from Jan.

• Jan was an uptick in inflation or “hot” data and it was not clear if Jan was trend change or “payback”
• While on surface core CPI seemed higher at 0.45% vs 0.41% in Jan, this was entirely a surge in “shelter” and in “travel”
• Feb payrolls and Feb CPI are downshifts so it looks more like Jan was the aberration
• And does Fed want to hike +50bp or even +25bp to slow “Travel” versus each hike damaging the financial system? Thus, we see reduced hikes

And ex-shelter, core CPI is tame at ~2%.

VIX: Returning to contango is good

The VIX term structure and VIX both went haywire Friday (last week) and Monday.

• VIX 1M went above 4M futures, or backwardation. This means markets saw near-term volatility event
• VIX surged above 30 too, meaning capitulatory surge
• both are waning, and a sign of risk-on

VALUATION: Ex-FAANG, S&P 500 P/E is 14.3X, hardly demanding

We hear investors say the market is too expensive. But this is distorted by the higher multiples of FAANG, and we think the higher multiples of FAANG are justified.

• ex-FAANG, P/E is 14.3X
• this is hardly demanding
• This is an earnings yield of 7%. That compensates investors enormously for risk taking, in our view.
• so, still think the equity market is expensive?

TECHNOLOGY: Still our favorite Sector pick for 2023

As we noted in our 2023 outlook, Technology is our top sector pick, which we expect to be led by FAANG.

• Technology and FAANG are now established meaningful breakouts as shown below
• this after sliding down the slope of hope in much of 2022
• this reversal has fundamental arguments

TECH EPS: Bottoming before the overall market

The two best performing sectors YTD (as of end of Feb) are:

• FAANG +1,180bp outperformance (vs S&P 500)
• Technology +210bp
• Defensives have been terrible, despite those arguing for a recession
• Tech/FAANG EPS has been slightly better than the overall market
• Thus, leadership is coming from groups with EPS bottoming

7 of 14 sub-groups in Technology seeing upward bias in EPS revisions

Take a look at 2023 EPS in the 14 sub-groups (GICS 4) of Technology.

• Half, or 7 of 14 are seeing upward bias in 2023 EPS revisions
• So, those saying Technology is a “sell” are overlooking that EPS momentum is turning positive

STRATEGY: VIX matters far more for 2023 returns than EPS growth

Our data science team compiled the impact on 2023 equity returns from variables:

• S&P 500 post-negative year (2022)
• the varying impacts of
• VIX or volatility
• USD change
• Interest rates
• EPS growth
• All of the 4 above, positive or negative YoY
• Data is based on rolling quarters and summarized below

The surprising math and conclusions are as follows:

• most impactful is VIX
• Post-negative year (rolling LTM)
• if VIX falls, equity gain is 22% (win ratio 83%, n=23)
• if VIX rises, equity lose -23% (win ratio 14%, n=7)
• I mean, this shows this all comes down to the VIX
• EPS growth has little impact
• If EPS growth is negative YoY (likely), median gain +14.8% (win-ratio 70% n=33)
• If EPS growth is positive YoY, median gain is 15.5% (win-ratio is 78%)
• Hardly a sizable bifurcation

As the scatter below highlights, we can see the sizable influence of the VIX. Even in all years, the VIX is a key factor:

• in our view, if inflation falls sharply
• and wage growth slows
• Fed doesn’t have to cut, but this is a dovish development
• we see VIX falling to sub-20
• hence, >20% upside for stocks

And as shown below, EPS growth has a somewhat important correlation, but hardly as strong as VIX changes.

• the difference in median gain is a mere 70bp (positive vs negative) post-negative year
• the importance of EPS growth is stronger in other years

STRATEGY: Financial conditions should ease in 2023, driving higher equity prices. Technology, Discretionary and Industrials levered to easing FCI

The “base” case for 2023 should be below. That stocks gained >1.4% in the first 5 trading days, and this portends strong gains for the full year:

• Post-neg year + up >1.4% on first 5 days
• Day 5 to first half median gain is 9.5%
• Full year median gain is 26%, implies >4,800 S&P 500
• 7 of 7 years saw gains.

Those 7 precedent years are shown below.

• the range of full year gains is +13% to +38%
• so, this is a VERY STRONG signal
• the two most recent are 2012 and 2019
• we think 2023 will track >20%

The path to higher equity prices is discussed above:

• core inflation falling faster than Fed and consensus expects
• wage inflation is already approaching 3.5% target of Fed (aggregate payrolls)
• Fed could “dovishly” leg down its inflation view
• allowing financial conditions to ease
• bond market has already seen this and is well below Fed on terminal rate

BASE CASE: The “maths” for what to expect in 2023, post a “negative return” year (2022)

Question: how common is a “flat” year? Our team calculated the data and it is shown below:

• since 1950, there are 19 instances of a negative S&P 500 return year. In the following year,
• stocks are “flat” (+/- 5%) only 11% of the time (n=2)
• stocks are up >20% 53% of the time (n=10)
• yup, stocks are 5X more likely to rise 20% than be flat
• and more than half of the instances are >20% gains

So, does a “flat year” still make sense?

As shown below, these probabilities are far higher compared to typical years:

• since 1950, based upon all 73 years
• stocks are “flat” 16% of the time vs 11% post-negative years — BIG DIFFERENCE
• stocks are up >20% 27% of the time vs 53% post-negative years — BIG DIFFERENCE
• see the point? The odds of a >20% gain are double because of the decline in 2022

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