Time to Hunker Down as SVB Financial Exposes a Growing Number of Naked Swimmers

Some fears of financial contagion crept into the market on Thursday. SVB Financial Group (SIVB) plunged 60% during the trading day and is down big again Friday.

SIVB is the parent of Silicon Valley Bank which is a key part of the venture capital and startup ecosystem in the San Francisco area. The company blindsided investors by selling almost all of its available for sale (AFS) securities which will trigger a $1.3 billion loss for the company. SVB also announced a huge, planned capital raise to bolster its liquidity.

The reason the bank is doing this is that leadership believes interest rates are likely to stay higher for longer than their previous projection. Obviously if this turns out to be a correct view, this will a huge headwind for the banking industry. Not surprisingly, banks were one of the weakest parts of the market on Thursday as the S&P 500 declined by nearly 2% on the day. JP Morgan Chase (JPM) was off nearly 5 1/2% and Wells Fargo (WFC) fell just over 6% during the trading day.

The news appears to have triggered a run on Silicon Valley Bank as venture capital firms withdraw their deposits. The stock is under $40 a share in early trading. As a metric around how fast things can go south in this environment, SVB Financial had a book value north of $200 a share at the end of the fourth quarter.

Pershing Square founder Bill Ackman is calling for a potential government bailout as “The failure of SVB Financial could destroy an important long-term driver of the economy as VC-backed companies rely on SVB for loans and holding their operating cash.” This saga could be a source of continued volatility for the market until resolved.

My regular readers know that for a couple of quarters now I have repeated my view often that the most aggressive monetary policy since the early 1980s wasn’t likely to stop until the Fed “breaks something.” We have already seen some spectacular blow ups in the cryptocurrency markets, and we can add SVB Financial to the list of “naked swimmers” being exposed by higher interest rates.

The inversion between the two- and ten-year Treasury yields hit 110bps earlier this week. The last time that happened was in 1969, 1978, 1979 and 1980. For those too young to remember, those were not good years for the economy or investors.

My portfolio is positioned as cautiously as it has been since the beginnings of the Great Recession. Approximately half of my holdings are now in cash and short-term T bills. The rest consists almost entirely of holdings bracketed within covered call positions for the downside risk mitigation features of this simple option strategy.

I moved some more of my cash to six-month T-bills on Thursday. I doubt I am the only investor making this “flight to quality” move. Getting an over 5% risk free return given the uncertain markets and economy seems a no brainer at the moment. There will come a time when it will be prudent to move money back into equities in a significant way. However, we are not nearly there yet.

Until then, my main investing focus will be return of capital vs. return on capital.