Covington Investment Advisors, Inc. Blog

Almost right on queue to our recent note regarding the Wall of Worry we had a new geopolitical event over the weekend as tensions escalated in the Middle East as Iran launched a drone and missile attack on Israel. Markets sold off at the end of last week in anticipation of the move but have stayed relatively tame as the chances of further escalation seem restrained, at least based on the rhetoric in response to the attacks so far. Let’s hope this is the case but this is a notoriously volatile relationship...

So far in 2024 markets have continued their strong run from last year as inflation has trended down, GDP has surprised to the upside, and the advent of artificial intelligence has given optimism for future productivity gains. This has culminated in one of the strongest market rallies of the cycle, led almost entirely by large-cap technology and growth.

Today's chart is probably our most commonly used one, showing the 20 year performance of the S&P 500 overlaid with the ‘Wall of Worry’- reasons for investors to sell stocks and get out of the market. But as can be seen, US stocks have had incredible resilience at powering through these apprehensions. So much so that looking back some of them seem incredibly insignificant in the rearview mirror or are even hard to remember.  ..

First Commonwealth Bank Corporate Banker, Patrick Thomas, and Assistant VP, Allisha Zeman, presented Laurel Highlands Workforce & Opportunity Center Board Chairman, Patrick Wallace with a $5,000 check from their Educational Improvement Tax Credit Program. This program sponsored by the PA Department of Community and Economic Development provides vital funding in support of educational institutions throughout the Commonwealth.

Shown from left to right: Patrick Thomas, Patrick R. Wallace..

Almost like the dog catching the car it appears we have finally reached the end of the Federal Reserve's tightening cycle as inflation has rolled over and the labor market has remained exceedingly strong. We think inflation remains sticky around 2.5%-3% and a resurgence cannot be ruled out which might keep the Fed on pause for longer than the market is expecting, but nevertheless the next significant move in rates will likely be lower. Markets have celebrated this with stocks staging a sharp rally to cap off 2023 and have carried that momentum into the beginning of this year. What's more is that the consensus view of an impending recession has yet to materialize.

In mid-2021 when inflation first took off and the Fed began signaling it would start raising rates markets went through a stretch of anxiety. Around that time we wrote a piece outlining how historically markets remained strong in the initial phase of hiking cycles with the caveat of increased volatility (that piece can be found here). However, even in the context of historical precedents the ensuing annual market swings exceeding 20% both up & down were exceptionally volatile. Such moves are usually associated with a recession.  ..

It's that time of the year again. Time to get together with family and reflect, but also to think about what's in store for the year ahead. Topics at your family gathering may be wide ranging but none are as exciting as the economy and markets. So in case these topics come up, we are here to help with 5 questions that we think are most likely to arise or you have yourself. For each question we suggest both a short and long answer - depending on if the topic comes up over dinner or dessert, and how lively the discussion is.  

1. Last year everyone was talking about a recession. Now economic growth is showing 5% percent. What happened?

 ..

This past Saturday, December 9th, 2023, we graduated our second class of Clinical Medical Assistants at the Laurel Highlands Workforce & Opportunity Center in Greensburg, PA.

My late father-in-law, Dick Dickert, used to say “You can change the world one life at a time”. Our second class of cohorts started with 12 individuals, 8 of which completed the 28-week program who became Certified Medical Assistants and the newest employees to our local medical system. As we pledged to eliminate every barrier that has precluded them from getting an education, these 8 individuals can now provide for themselves, their families, and our community...

A recent Wall Street Journal article declared “Your Investment Strategy is Broken”. This declaration was made as stock and bond prices have moved in tandem negatively in 2022 and during parts of this year. Traditionally prices of stocks and bonds tend to move in opposite directions, balancing out volatility through various economic conditions. That has not been the case over the last two years as the Fed aggressively hikes rates to fight inflation. Apparently the author of this article believes those are the only two asset classes and that centuries-long human nature has permanently changed in the last three years. I feel this is a sensationalist and dangerous message to be dispersing and would like to restate why our investment approach is not one that is, or can ever be, “broken”.

Our investment strategy approach starts out by incorporating an emergency cash fund. What allows our strategy to work is patience, diversification, and discipline. Having an emergency cash fund so as not to be forced to liquidate long-term holdings at the wrong time is foundational to this. Once we have an adequate cash position built up we begin tailoring a customized plan and building a budget so we can begin appropriately investing long-term funds. Today we are getting back to an environment where we can earn a reasonable yield on cash. That is a welcomed development especially when compared to the recent past where we were lucky to get a couple basis points of yield on idle cash. This provides us a good short-term solution and allows patience while thoughtfully deploying capital into each of your long-term investment programs. Having adequate cash reserves is paramount, but as we will outline later in this note, excess comfort comes at a high price in the investment world...

The US economy is currently in the late cycle of an economic expansion where economic growth is slowing, but it is still positive. This phase is typically characterized by rising inflation, tighter monetary policy, and increased volatility in the stock and bond markets, all of which you have seen over the last two years. We have been warning of this as several indicators have begun to point towards the US being in late cycle and many signaling the US entering a recession in the next 12 months. The root cause of these developments has been the fed’s monetary policy of raising rates to mitigate the impact of higher inflation.

In the face of rising inflation, the Federal Reserve has embarked on their most aggressive rate hiking cycle in decades which will eventually slow down the economy. On the other hand, record low unemployment, large fiscal deficits, and strong household balance sheets have buoyed the economy and markets. But still, looking ahead, every time the Fed has embarked on a tightening cycle, an economic slowdown has followed, and with it, market volatility. However, the unusual nature of this post COVID cycle has distorted the normalization of rates and its impact on the overall economy. Even though the timing of this economic cycle may be different from past cycles, the principles for managing it remain the same.

Part of our job as your advisor is not only managing assets but managing emotions. Markets by nature are unpredictable because ultimately it is people that are transacting assets. We have commented before on the “manic depressive” nature of investors whereas they become too fearful close to the bottom and too euphoric close to the top. This creates both difficulties and opportunities. The difficulties come because it is never pleasant to weather a sell-off and see negative numbers. The opportunities come because extreme pessimism during selloffs is what gives investors opportunities to deploy capital into assets at attractive prices below their intrinsic value. This can come in the form of excess cash, dividend reinvestment, or companies themselves deploying retained earnings. This also hinges on owning a diversified portfolio of proven enterprises that have strong balance sheets and provide cash flow to shareholders even through the trough of market cycles. This has always been our bias...

Quite the turnaround from last year, markets have clocked a strong first half of 2023 with the S&P 500 and NASDAQ both up double digits. What's more is that this overall reversal in market performance applies to sub sectors with many of the worst performing pockets of 2022 being the best performers in 2023. Of course the leader this year has been large-cap tech which got pummeled in 2022 but has roared back accounting for almost all of the broader index’s return in 2023. We wrote about this recently in a note which can be found here. Fixed income markets have also stabilized and now offer pretty attractive yields across the curve...

The first half of 2023 has felt very similar to the tumultuous years of 2020 and 2021 which saw the market dominated by mega-cap tech stocks. The average YTD return on Amazon, Apple, Google, Meta (Facebook), Microsoft, Nvidia, and Tesla is 84%. The average YTD return for the rest of the S&P 500 is just 3.7%. In fact, when breaking down the contribution to the index’s total year-to-date returns this chasm becomes even more apparent – ten stocks contribute all but 1.4% of the returns which is shown in today's chart above. This is the most narrow breadth in the market since the tech bubble in the early 2000’s.

What's driving this? A lot of it is optimism over the proliferation of artificial intelligence (AI) and multiple expansion for the previously listed top ten stocks. Many of these are now priced at or near the top end of their historical valuation range which is puzzling considering those previous highs were when interest rates were near 0%. For Meta and Nvidia, sharply increased earnings expectations are also part of the explanation for their meteoric rise this year. For the other five stocks mentioned in the first paragraph of this note, earnings expectations are either flat, or in the case of Tesla projected to fall due to $2k-$10k price cuts for the Model Y, S, and X vehicles (which hasn't prevented Tesla from rising by over 90% in 2023)...

May 10, 2023

Twenty years ago today, Covington Investment Advisors was incorporated. The success we have had with and for our clients has allowed us to grow, hire more talent, continually enhance our technology and research, purchase and expand our building, expand our overall processes to customize your financial plans, providing best in class investment management services and results and contribute to our communities' societal needs.

I do not hesitate to say we have formed the best-in-class advisory firm as we are not a broker dealer, nor are we affiliated with one. As an independent advisor, we have an open architectural structure to find the best financial solutions for you. We cut out all the unnecessary middlemen and their fees and we refuse any form of commissions. We are a fee-based only advisory firm. We do not sell products; we provide customized financial plans structured and managed on a separate account basis driven to address your individual investment and family needs. As a federally registered investment advisor with the Securities & Exchange Commission’s (SEC) oversight, we are a corporate fiduciary held to the highest standard of care...

Financial advisors and their clients must stand guard at AI’s gate.

In a quote whose origin has been misattributed to Mark Twain and Benjamin Franklin, it was Christopher Bullock writing in 1716’s “The Cobbler of Preston” who first noted, “’Tis impossible to be sure of anything but death and taxes.”

Fast forward 307 years, and we are forced to include computer-generated misrepresentations. And this modern malady is legion, and insidious, in so many things we do...

Recent headlines on the banking crisis have most likely brought up questions on the safety of your money and assets. This blog will hopefully clarify those concerns.

Charles Schwab, like all federally registered regulated banks, has insurances in place to offer additional protection to their customers. In summary, there is SIPC insurance which covers up to $500,000 in cash and securities per account holder - $250,000 limit for cash. SIPC covers account holders if the firm fails and cannot return assets and covers unauthorized trading or theft of their securities. Additionally, Schwab has FDIC insurance which traditionally covers up to $250,000 per account holder in deposit accounts like bank sweep products and CD’s should a bank fail. In the case of Silicon Valley Bank, FDIC made exceptions and guaranteed ALL deposits – so the limit of $250,000 is up for interpretation. Lastly, Schwab has in place “excess SIPC” insurance of $600M for securities and cash if the first two programs are exhausted.

Here is a link that explains the account protections that Schwab has in place: Is my money safe - Account Protection | Charles Schwab..

Not a barcode… Today's chart plots the frequency and duration of every post-Civil War recession in the United States. If the year has a blue bar that indicates the US economy was in a recession or decline in business activity for the period.

As the Fed embarks on their capital tightening cycle to tame inflation we are likely nearing the end of this expansion pointing to perhaps one of these blue bars appearing in the next 6-12 months. In past notes we have hinted at the likelihood of this occurring and what it would mean for asset prices and long term investment portfolios. See here, and here...

I am sure by now you have seen the headlines of the failure of Silicon Valley Bank (SIVB). Our President wrote a letter on Monday (here) touching on the situation but also outlining what we are prepared for as we progress through this broader economic cycle. In this note I want to expand on that letter and give a more specific commentary on what took place at Silicon Valley Bank and how it reached the point of collapse. In this note I focus on SIVB but the same characteristics are shared by Signature Bank (SBNY) and First Republic (FRC) which have also gone under or are under significant stress.

Silicon Valley Bank is a chartered bank in Santa Clara California. In many ways SIVB operated like any normal bank. A classic bank has short-term deposits and long-term assets. Depositors loan their money to the bank for an interest rate payment. That bank then loans that money to fund useful projects that earn a higher interest rate payment (typically in bonds, stocks, loans, mortgage backed securities, etc). As long as the depositors do not withdraw their funds, the bank earns a profit. The deposits are liabilities to the bank and the loans are assets to the bank. All banks also use a fractional reserve system where they only hold a fraction of their deposits in liquid “cash”. The fractional reserve system is often characterized as a sinister system but it’s the main vessel of money creation in our modern economy. The drawback is if enough depositors rush to the bank to withdraw their money at the same time you get a “run on the bank” leading to a collapse of that bank. The FDIC tries to mitigate the risk of this by guaranteeing up to $250k of a depositor's money so as to provide confidence to depositors that their savings will not just vanish. Since Friday the federal government announced protections for depositors at SIVB above the $250K limit. But as can be inferred from this whole dynamic, a bank run can be a self-fulfilling prophecy where if key depositors withdraw their funds from the bank, that can scare other depositors into withdrawing their money ultimately resulting in a state regulator to call in the bank and dissolve it.

So SIVB pretty much followed this typical bank failure model but with some nuance which gives hints as to what is happening to the broader economy. SIVB saw a huge inflow of deposits in the last 3 years as their client base of speculative tech companies have been perhaps the main beneficiary of the fiscal and government stimulus policies. SIVB received this huge inflow of deposits from their technology/VC/crypto clients and they could not figure out how to invest all those funds into high yield assets since rates were so low. Thus, SVB ended up purchasing low-yield, long duration, but relatively safe mortgage backed securities and long term bonds that were intended to be held to maturity (HTM)...

Business cycles are intervals of expansion followed by slowing growth or a recession in economic activity. These cycles are driven by many macroeconomic factors, but our government policies serve as the governor to the economic engine.

Current Fed policy measures are being implemented to break the current economic expansionary phase of this economic cycle. Yes, the Fed wants to break this exuberant economy and slow it down to mitigate the pressures of accelerated inflation. With the government actions to save us from COVID the economy has been running too hot. 500,000 new jobs created in January followed by 300,000 new jobs in February with 10.8 million current job openings posted the Fed has no choice but to take aggressive action to normalize growth and purge excesses from the economy.

Warren Buffet said it best about the effects of such measures: “It is at these times that when the tide of economic expansion runs out to sea we see who is swimming naked.” When liquidity, or access to capital, is fluid and cheap all kinds of companies thrive. When capital is pulled from the economy and becomes expensive profit margins suffer. Strong businesses with sound fundamentals survive while the weak and unproven enterprises perish. This is why I have always professed that we invest in proven enterprises with strong economic fundamentals...

Not quite as salient in markets as inflation, but certainly occupying the headlines has been the pending battle on raising the debt ceiling. Congress has always placed restrictions on federal debt. These limitations have helped Congress assert its constitutional powers of the purse, of taxation, and of the initiation of war. Since WWII, Congress has raised the debt limit 78 times and suspended it another five times. For most of the post-war period debt limit increases were considered routine legislative chores that never engendered much debate or public scrutiny. The current debt limit of roughly $31.4 trillion was reached this quarter prompting the discussion to begin on raising the debt limit in order to maintain the country's spending habits. You'll remember we went through a similar episode in 2021 when the debt limit was reached and subsequently raised but only by enough to prevent a default until the beginning of this year -  Thus here we are now having the current debate.

A deeply divided congress still has five or six months to reach a deal on raising the limit and avoiding a default or funding delay in the US treasury market, which is an integral component in the global financial system. Both sides are dug in early with Republicans saying they won't agree to a debt limit increase unless it accompanies spending cuts (although most spending appears to be off the table). Democrats say they will only support a debt limit increase without cuts or other changes. You'll remember in the 2021 episode which we wrote about at the time (here), both sides of congress used the element of political brinkmanship which rattled investors. This involves waiting until the very possible last moment, but ultimately hammering out a deal because they realize the consequences of not doing so would be catastrophic. We never like to assume, but feel that the situation this time around will play out similarly. For politicians there is no reason not to take things right down to the wire like they did in 2021. A government shutdown might even take place which does not affect markets much if it only lasts a few weeks...

Deflation in 2020/21. Inflation in 2022 … Stagnation in 2023?

During the covid lockdowns starting in 2020 deflation dominated markets as economic velocity and prices plummeted. US treasury yields fell to an all-time low bumping under 0.5%, growth stocks soared, and speculative phenomena such as NFTs and crypto went mainstream. During this time the US tech sector market cap rose to over $7 trillion...

As we reflect back on a tumultuous 2022 and begin to look forward to 2023 we are not only preparing for our new year outlook but also what topics are on everyone's minds, including our own, over the holidays. We have listed the notable questions and what our take is on each one, both a short answer and a more nuanced view. So if the economy comes up in those lively holiday conversations hopefully these provide some interesting discussion material.

1. “Are we in a recession? We have had two consecutive quarters of negative GDP growth this year, isn't that a recession?”

Short answer:Not yet. 

Long Answer:  Although two quarters of falling GDP meets the definition of a “technical recession”, from an economic perspective weakness has to broaden out to a wider range before it meets the criteria for an official recession. The National Bureau of economic research (NBER) makes the official call on whether the economy is in a recession. To do this they use 6 economic indicators which are more expansive than just GDP which can be impacted by large swings in trade and inventory data (which we have seen this year). ..