Macroeconomic forces will likely dictate the market's near-term direction, so does that mean tech buyers are whistling past the graveyard?
It's true, the tumultuous week in the banking sector barely registered on the S&P 500, after tech stocks staged a staggering rally, led by artificial intelligence-related stocks such as Nvidia (NVDA) , Advanced Micro (AMD) , Microsoft (MSFT) , and Alphabet (GOOG) . Bank failures and financial instability led to an epic bond rally, with lower rates unleashing tech bulls. The disproportionately tech-heavy weighting in the indexes masked the banking woes and all but ignored the potential economic toll.
Yet, banking issues have put the Fed on a more cautious path of rate hikes. The Fed had seemed determined to continue hikes into the summer, but the fallout from stresses in the banking system could dictate stopping hikes or even reversing rates. The goal of rate hikes is to slow economic activity, now accomplished by the latest bank failures that will undoubtedly take an economic toll. But the Fed is still looking at stale data and may raise an additional quarter percentage point at this week's Fed meeting.
Nobody would argue the justification if the entire market traded lower last week; instead, a fierce rotation into technology drove the S&P higher. Tech stocks seem a natural safe haven, with strong balance sheets and cash flow generation. The rub has been that multiples are rich -- and what valuation makes sense if the economy rolls off the rails?
The demise of Silicon Valley Bank (SIVB) as we knew it has a potential parallel to the post 2000 Nasdaq bubble when internet tech startups lost funding opportunities, depleting a rich source of tech purchasing power. Yet, the tech sector is far more diversified and big-cap tech is far less frothy. For starters, the case for owning Apple (AAPL) is still clear, with its market share gains worldwide, ever-broadening service and product lines, and push for improved margins by developing chips and screens in-house.
The profound advancements in AI will feed through the entire tech food chain. Although valuations in some areas are rich, fade the AI revolution rally in top tech names at your own risk. More prudently, patience may be necessary for better entry levels on weakness instead of chasing higher.
Stress in the financial sector offers an uncomfortable gut check. Compared to 2008, this banking crisis seems quite mild. There are no impossible-to-value toxic debt instruments leveraged beyond comprehension in a sector sure to lose value, like housing was during the Great Financial Crisis. Today, interest rate risk and duration risk on money good assets seems manageable, especially for larger banks. Still, small and mid-sized banks are impaired, and they are critical drivers of credit growth, accounting for over 60% of commercial real estate lending.
As Morgan Stanley's Mike Wilson points out in his latest dispatch, the risk of a credit crunch has increased materially from tighter lending standards across the banking industry. At a minimum, tighter lending conditions will likely do the Fed's job of slowing the economy, leaving the Fed largely on hold after Wednesday's meeting. Wilson's concern jibes with Jim Chanos' recent warning to avoid companies with business models that rely on third-party funding to finance its operations.
The good news for banks is that opportunities are created as the market discounts money good holdings due to higher interest rates. The assets are apt to appreciate over time as duration shortens, accruing gains to stock buyers on weakness. Plus, if the precipitous fall in yields continues, value will flowed back to bond portfolio holdings. The risk is far less in the discounted holdings, which is more a weight on net interest margin for the larger banks, than if this banking crisis morphs into an economic and commercial real estate problem. Indeed, within last week's rotation, economically sensitive stocks were especially weak, already discounting more challenging times ahead. A clear recessionary signal was sent in oil and commodity stocks.
The economic storm clouds grew darker last week, making a good case for markets to trade lower in the coming months. Still, portfolio diversification and some dry powder are prudent. The most predicted recession in history and the associated cautious positioning leave open the question of how much bad news is already priced into stocks. From a top down, an 18-19 multiple on earnings seems high, but under the surface of richly valued big-cap tech, valuations are generally reasonable. A 5%-10% market decline is on the table, and just the buying discount that a final bear scare could bring before a new bull emerges.
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