Episode 45: Is Hyperinflation Coming?

As bad as inflation has been, Gerry and Doug are skeptical about claims that it will devolve into the dreaded hyperinflation. Still, they like crypto.

Episode 44: Gerry Can't Drive 55

Instead of being mad at the Fed this week, Gerry is mad at traffic. Once's he's done with that, he and Doug talk about the advantages of venture capital, the good old days (and how they weren't always so good) and whatever else comes to mind.

Getting back to real investing, March 2023 edition

ABOVE: An actual bank run, in Germany in 1931 -- not a scene from a movie!

image: Wikimedia Commons (link).

In the wake of the failure of Silicon Valley Bank last week (and Signature Bank of NY over the weekend, both of which followed closely on the failure of Silvergate Bank earlier in the week), plenty of news outlets are describing the cause as "an old-fashioned bank run," often adding a reference to the famous bank-run scene from It's a Wonderful Life (1946).

In one sense, that comparison isn't inaccurate, but there are some very important differences too -- differences that investors living in 2023 should take time to understand.

As Bloomberg author Matt Levine explains in a very well-written article here, Silicon Valley Bank "could probably have muddled through and been profitable if people had just kept their money in the bank: Its maturities were laddered, its deposit rates weren't going up that much, it did have a positive net interest margin even this quarter, it did have various ways to make money, and if people had just kept their money in, the bonds would have matured and been replaced by higher-earning bonds and SVB would have been fine." 

He explains that the bank also would probably have survived if it had been allowed to borrow from the Fed against its assets at the face-value of those assets -- but that if the Fed insisted on marking those assets down (due to the rising interest rates resulting from the Fed's extremely rapid and steep tightening over the past twelve months) following "mark-to-market" accounting, then such markdowns would make SVB insolvent in the face of rapid withdrawals, which is exactly what happened. 

If you are not a banker and don't necessarily understand the mechanics of the above description, check out Matt Levine's article. But we would point out that the possibility of insolvency due to a bank run is well understood and not a new danger -- and the banking system has had safeguards in place for almost a hundred years in order to prevent people from losing all confidence in the system and pulling their money from every bank when they see banks start collapsing the way we have seen three banks collapse over the past several days.

So what is new and what is important to understand about the current situation? 

What is different from the bank runs of the Wonderful Life era is the fact that we are now in an era that enables the constant moving of money using mobile devices -- a phenomenon that was not present until the rise of the smartphone, which has transformed society so thoroughly that even fairly recent movies made before the advent of the mobile era look like they are set in a completely different world from the one we live in today (and in many ways, they are).

In fact, the most-recent financial crisis of 2008-2009 (which was caused by a different set of banking mistakes than the ones we are seeing take down the banks this week) was itself a crisis that took place prior to the current era of mobile money movement: the very first iPhone did not even appear until the year 2007, and it took a few years before smartphones became ubiquitous the way they are now.

This important transformation of society since the appearance of the smartphone cannot be emphasized enough -- and it should be noted that the Fed has not raised rates as much and in such a short period of time as it has recently, at least not in most people's memory. 

The mobile era makes it very easy for depositors to pull their money out of a bank in a heartbeat (they don't have to crowd into a physical building or line up around the corner, the way they did in Its a Wonderful Life or in the actual bank run shown in the photo above). 

On the other side of the balance sheet, the bank holds assets which counterbalance the deposit accounts that the bank owes to its depositors.  The bank may be forced to sell or borrow against these assets in the event depositors start demanding their deposits back en masse. In the modern era of high-frequency trading of bonds and other securities in which banks typically invest, and since those bank assets are "marked-to-market", this can result in a bank becoming insolvent very quickly.  

In the current case, these bank's bond portfolios were hit hard given the rapid rise in interest rates engineered by the Fed in the wake of rampant inflation, which was itself brought on by profligate government spending (some $10 trillion in two years!).  A year ago, at the beginning of March 2022, the effective Fed funds rate was only 0.8%. Today, the effective Fed funds rate is 4.57%.

All of this is connected! We now live in an era of mobile money, in which investors have been encouraged to make second-by-second valuation decisions and second-by-second trading decisions -- and in which bank assets can be marked-to-market on a second-by-second basis. 

This mentality can lead to bank panics like the one that took down Silicon Valley Bank. If depositors get spooked, they can pull their deposits almost instantaneously, and if the system that is supposed to enable banks to borrow against assets now insists on marking those assets down to their immediate market values (instead of valuing them as if they will be held-to-maturity), then collapse becomes almost inevitable.

Another important difference from the famous scene in Its a Wonderful Life: in that movie, the townspeople who were panicking and starting the run on the bank were portrayed as simple, honest, hardworking men and women. They were not sophisticated investors: they were just ordinary people who needed to pay a doctor bill or buy food to make it through the week. 

But the depositors who frequented Silicon Valley Bank included some of the wealthiest venture capitalists and institutional investors in the world, as well as the young companies they funded. The same can be said for the trading firms who made up the majority of the depositors at Silvergate Bank, as well as those who frequented Signature Bank of New York. 

As professional investors ourselves, we have never bought into the "fast money," nanosecond-by-nanosecond, "flash trading" schemes favored by these supposedly sophisticated institutional investors. The  collapse of Silicon Valley Bank shows that when it comes to a bank run, the venture capitalists and self-styled "tech investors" of Sand Hill Road act a lot like the panicking townspeople of Its a Wonderful Life, except that in the age of mobile devices and instant money movement, they can pull their deposits out a lot quicker!

In fact, this whole sorry spectacle highlights what we have been preaching for decades: that investors need to get back to real investing. The smartphone-era, second-by-second money movement, and the idea that investors should be pursuing real-time changes in "valuation," is only the latest and most-destructive phase of the decades-long arc of so-called "modern portfolio theory".  It is our view that this theoretical analysis, which de-emphasizes the importance of fundamental analysis of an investment and replaces it with an almost cult-like worship of the ability of "the market" to accurately value everything instantaneously, has hijacked the investment world and convinced too many investors that investing all comes down to algorithms.

To us, "getting back to real investing", means evaluating businesses (or bonds or any other securities) based on their fundamentals, and investing in them for their long-term prospects, through the ups and downs of the panic-of-the-moment. It is the opposite of the kind of short-term focus that has characterized most fast-money institutional managers, and which has spread to just about anyone with a smartphone (just imagine if the crowd in Wonderful Life had all had smartphones and trading accounts!).

Sadly, even the most (supposedly) sophisticated investors, including Silicon Valley venture firms, have been caught up in two decades of malinvestment built on short-termism and the demise of what we call real investing. Perhaps the events of this week will lead to a re-evaluation of these very serious problems and a change for the better. At least, we certainly hope that they will.

* Disclosure: At the time of publication, the principals of Taylor Frigon Capital owned shares of ClearPoint Neuro (CLPT).

Disclosures: Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Taylor Frigon Capital Management LLC (“Taylor Frigon”), or any non-investment related content, made reference to directly or indirectly in this blog will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this blog serves as the receipt of, or as a substitute for, personalized investment advice from Taylor Frigon. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. Taylor Frigon is neither a law firm nor a certified public accounting firm and no portion of the blog content should be construed as legal or accounting advice. A copy of the Taylor Frigon’s current written disclosure Brochure discussing our advisory services and fees is available upon request. If you are a Taylor Frigon client, please remember to contact Taylor Frigon, in writing, if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services, or if you would like to impose, add, or to modify any reasonable restrictions to our investment advisory services.

Episode 43: SVB Blows Up

The guys rehash what everyone is hashing: Silicon Valley Bank. Then, Doug hijacks the show and lets loose on Covid policies.

Episode 42: Fit To Spit

Does the Fed have as much control over inflation as we think? Also, Gerry and Doug finally realize that it is hard to complain about over-focusing on the Fed without over-focusing on the Fed.