SIVBP - Ray Dalio Says Economy Is At A 'Turning Point' - SPY Implications

2023-03-24 11:00:36 ET

Summary

• Billionaire Ray Dalio recently predicted that the SVB failure will have a significant impact on the economy beyond just the Venture Capital space.
• Multiple other prominent investors seconded this opinion, agreeing that the economy is at a turning point.
• We discuss the implications for the S&P 500.

Billionaire Ray Dalio recently predicted that the SVB failure will have a significant impact on the economy beyond just the Venture Capital space. Multiple other prominent investors seconded this opinion, agreeing that the economy is at a turning point. In this article, we examine their concerns and discuss the implications for the S&P 500 ( SPY )

Ray Dalio's Concerns For The Economy

Billionaire investor Ray Dalio recently warned in a newsletter that Silicon Valley Bank's ( SIVB ) failure is a "canary in the coal mine" moment for the global economy:

It is classic that coming out of an extended period of very low real interest rates and abundant credit, there is an enormous amount of leveraged long holding of assets that are going down... This bank failure is a 'canary in the coal mine'...[an] early-sign dynamic that will have knock-on effects in the venture world and well beyond it... It is a very classic event in the very classic bubble-bursting part of the short-term debt cycle... It is likely that this bank failure will be followed by many more problems before the contraction phase of the cycle runs its course... Looking ahead, it's likely that it won't be long before the problems pick up, which will eventually lead the Fed and bank regulators to act in a protective way. So I think we are approaching the turning point from the strong tightening phase into the contraction phase of the short-term credit/debt cycle.

The Bridgewater Associates founder said the event was an early sign of knock-on effects in the venture world and beyond, as regulators stepped in to close down the bank, amid a wider crisis in the US banking system. Other billionaires including BlackRock ( BLK ) CEO Larry Fink and Pershing Square Capital Management ( OTCPK:PSHZF ) founder Bill Ackman have also warned of further bank failures and tighter capital standards as a result of the situation.

Moreover, Moody's recently downgraded its US banking system outlook , stating:

Pandemic-related fiscal stimulus along with more than a decade of ultralow interest rates and quantitative easing resulted in significant excess deposit creation in the US banking sector. This has given rise to asset-liability management challenges, with some banks having invested excess deposits in longer-dated fixed-income securities that have lost value during the rapid rise in US interest rates.

SPY Implications

What does this mean for the S&P 500 and large low-cost index funds like SPY? The immediate good news is that only 12.71% of the index is in the financial sector:

Moreover, none of its top 10 holdings - which make up a whopping 27.12% of its total portfolio - are in the banking sector (though Berkshire Hathaway ( BRK.A )( BRK.B ) does have substantial stakes in banks like Bank of America ( BAC )):

In that sense, SPY is well-insulated against the immediate fallout from the banking crisis. Moreover, its top holdings are considered safe-havens by many investors given their powerful moats and cash-rich balance sheets. These two factors largely explain why SPY has held up relatively well so far in the face of the banking ( KBE ) crisis:

However, as Mr. Dalio and others alluded to, this may not prove to be the case moving forward.

First and foremost, while the quarter of its portfolio allocated to large and mega cap tech should be relatively immune to this headwind thanks to their cash-rich balance sheets, large swaths of corporate America are likely going to be facing major challenges due to tighter lending standards and higher interest rates for longer. While many sectors have not yet priced this in, one area where it is very visible already is in real estate ( VNQ ), as illustrated by the sharp sell-off in the sector since the beginning of February:

While it constitutes a mere 2.62% of SPY at the moment - so it has only had minimal impact on its performance over that period - the trend could soon pop up in more significant sectors of SPY's portfolio. This is because - thanks to a decade of historically low interest rates and easy access to capital - debt-fueled share buybacks have soared , leaving corporate America as leveraged as ever:

Moreover, thanks in part to soaring inflation, U.S. households are also facing record - and dangerously high - debt levels , including record high credit card debt that has left consumers near a "breaking point" according to some studies .

What this means is that a lot of consumption has been pulled forward for U.S. consumers and - with the Federal Reserve forced to keep interest rates dramatically higher than they have been in a long time in order to combat stubborn inflation - it is increasingly likely that the economy has reached a breaking point. Once layoffs begin to pick up speed (which Chairman Powell has already stated is his objective and a necessary price to pay in order to battle inflation), consumer spending is likely to drop dramatically as declining consumer purchasing power will probably combine with plummeting consumer sentiment.

This will likely leave no sector unscathed, but the hardest hurt ones will likely be four out of the five in SPY's portfolio (making up 57.77% of its total holdings): technology (26.23%), financials (12.71%), consumer cyclical (10.39%), and industrials (8.44%). Companies like Apple ( AAPL ) and Amazon ( AMZN ) will likely be hit especially hard as consumers pull back sharply on the purchase of expensive new phones and other electronic gadgets along with less money for impulse shopping online via Amazon. Financials are already suffering, but the pain will likely only increase as loan defaults soar and business activity slows. Consumer cyclical and industrial businesses by definition see wide swings in profitability across business cycles, so both of these sectors will likely be hurt by a recession, especially if it is a sharp and/or protracted downturn.

When you combine these likely secondary impacts from the banking crisis along with the Fed's hawkish interest rate policy, SPY's current valuation is anything but attractive. According to the S&P 500 Mean Reversion valuation model, SPY is currently 32% above its exponential historic trend line. The Interest Rate valuation model has SPY 0.9 standard deviations above its historical trend. The Price to Earnings valuation model has the current CAPE ratio at 37.1% above its long-term historic trend. Last but not least, the Buffett Indicator model has the market at 0.7 standard deviations above the historic trend.

Investor Takeaway

What does this mean for investors? While we do not advocate overreacting and selling all of your stocks, now looks like a very unattractive time to be buying shares of SPY. While the economic fundamentals continue to deteriorate, SPY's valuation remains elevated relative to historical trends. Moreover, we expect the negative economic news to only spread to other sectors of the economy as the massive debt bubble pops beyond the banking sector. Once this becomes apparent, we expect other sectors of the stock market - which have held up admirably thus far - to begin feeling similar pain to that being experienced by banks and REITs at the moment.

That said, at High Yield Investor, we are not panicking and heading for the hills by piling into cash. Rather, we are remaining invested in stocks, but are being very strategic in where we are investing. For example, we do not have anything invested in technology, very little invested in industrials and consumer cyclical stocks (and even then, we only hold businesses with solid balance sheets, strong moats and management teams, and trading at very steep discounts), and we have very conservatively and closely approached the banking crisis by buying shares in New York Community Bancorp ( NYCB ) hand-over-fist near the bottom and then quickly reaping 40% profits on the jump after it snagged assets from failed Signature Bank ( SBNY ) for pennies on the dollar. Moreover, we are investing the vast majority of our capital into undervalued, investment grade, and highly defensive businesses found in the energy midstream ( AMLP ) and utilities and infrastructure ( XLU ) sectors alongside considerable exposure to gold and copper miners ( GDX ) as well as a few other anti-fragile businesses that generally profit from spikes in market volatility.

In conclusion, while we rate SPY a Sell right now, we still think there are pockets of considerable opportunity in the stock market for investors who are willing to diligently and opportunistically manage their portfolios.

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