1st Quarter Review: A Roller Coaster Ride Ends on a Positive Note

U.S. stocks got off to a strong start in January, rallying about 7%. Meanwhile, bonds were more or less flat as investors bet that the Federal Reserve ("Fed") was nearing the end of its rate-hiking cycle.

However, the mood darkened in February when it became clear that lingering inflation and a strong job market meant the Fed’s work wasn't done. As a result, stocks and bonds fell sharply. Following the failures of Silicon Valley Bank and Signature Bank in March, both growth stocks and bond prices staged a strong comeback, while financials and value stocks lagged. The regional banking crisis shifted the Federal Reserve's attention from lowering inflation to ensuring the banking system's stability, and the yield on the two-year treasury note quickly reflected this abrupt shift in focus:

 And yet, here we are. The S&P 500 ended the quarter up 7.5%, and the tech-heavy Nasdaq is up almost 21%. International stocks also performed well (The MSCI Index was up 8.6%), partly helped by a weakening U.S. dollar against the Euro and other major currencies (all performance numbers include the reinvestment of dividends).

The Barclays Aggregate Bond index—a proxy for the U.S. bond market—was up 3%, with the 10-year Treasury yield declining to 3.5%. Our average balanced portfolio lagged a balanced index (the mix is about 65% stocks/35% bonds) but was up in the low single digits—hardly a disaster and most likely a surprise to most of you.

The chart below illustrates that, despite the volatility of the past 12 months, equity markets have provided higher than average returns for the past three years (note that this period now overlaps the market low during the Covid outbreak in March 2020):

 With short-term yields on high-quality bonds and U.S. treasuries approaching 4.5% to 5%, we continue to favor funds with short maturities or actively managed bond funds rather than a broad intermediate bond market index. Moreover, when appropriate, we proactively invest your cash in money market funds or treasury bills to capture higher yields.  

Toward the end of the quarter, we began reducing your allocation to arbitrage and certain preferred stocks, reallocating the proceeds to short-term fixed income. These investments outperformed cash and bonds for the past few years, but the prospective risk-adjusted returns seem less attractive now.

Large Cap Value Review

(Not all clients of Bristlecone are invested in our Large Cap Value Equity portfolio strategy, depending on the overall portfolio size and the client's objectives and constraints.)

 Within the U.S. stock market, the stars of the quarter were the laggards of 2022. Growth outperformed value, financials were crushed in March (even if somewhat indiscriminately), and the two biggest winners were communication services and technology. As is frequently the case, tech’s resurgence was led by a handful of mega-cap stocks (Meta, Apple, and Microsoft), slightly obscuring the lower performance of the average stock in the market.

Our Large Cap Value portfolios were up in the low single digits during the quarter, exceeding the Morningstar Large Value index return but underperforming the S&P 500.

In January, we sold two successful long-term investments, Pfizer and Weyerhauser, to free up some capital to increase our position in Disney and initiate a new investment in CarMax (ticker: KMX). Our appraisals of each company’s value are well above the current market price, and their shares are more likely to deliver market-beating returns in the next few years than those we sold.

We already discussed our rationale for Disney in our 4th quarter 2022 comments. CarMax sells, finances, and services used and new cars through over 230 retail stores. It was formed in 1993 as a unit of Circuit City and spun off into an independent company in late 2002. CarMax is the largest used-vehicle retailer in the U.S. yet it has only about 4% (company estimate) of the U.S. used car market.  

A traditional dealership relies on profits from service to offset the typically lower margins it gets on new-vehicle sales. CarMax's business model differs: its salespeople receive the same commission regardless of the vehicle sold. This creates a better customer experience. Management also follows the COSTCO strategy: CarMax's scale allows it to lower costs, which it passes on to customers through lower pricing. This gives us confidence that the company will keep growing its market share. The recent disruptions in the automotive industry gave us an attractive entry price.

Finally, we should discuss the situation with our banks. Without going into too many details, it is helpful to understand the factors that led to the government closing two banks in March.

Banks play an essential role in a modern economy: they act as intermediaries between savers and borrowers. Savers deposit their money in a bank, which then lends it out to borrowers who need it. Banks profit by charging borrowers a higher interest rate on the loans than they pay savers on their deposits. This is called the net interest margin.

In essence, banks facilitate the flow of money from savers to borrowers, providing a valuable service to both parties. Savers earn interest on deposits while borrowers access much-needed funds to finance their projects or purchase goods and services.

As illustrated in the movie "It's a Wonderful Life," trouble arises when too many depositors want their money back—the so-called “run on the bank.” Their funds are loaned out. Banks typically keep some liquidity but not enough to cover a very high rate of withdrawals in a short period. When that happens, a bank goes bust.

The banks that recently ran into trouble had specific issues (concentrated depositor base, poor risk management, etc.). Our bank holdings—Bank of America and Wells Fargo—are not exposed to the same risks. If anything, they have benefited from their designation as “systemically important” (i.e. “too big to fail”) and attracted a flood of deposits from smaller regional banks perceived as less secure. That said, we expect their net interest margins to decline as depositors seek higher returns on their savings, but the net impact will be somewhat muted now that the banks are also earning higher yields on their loans.  

How Safe Is Your Money?

With these recent unsettling headlines affecting banks, we thought it worthwhile to review and explain what layers of protection are available to your depositors' and investors' accounts.

Your Bank Deposits  

The money held in your checking or savings accounts is protected by an independent agency of the federal government called the FDIC (Federal Deposit Insurance Corp). If your bank fails, you will be made whole, subject to some limits and exclusions:

• The FDIC Insurance covers checking and savings accounts, money market accounts, and certificates of deposit.
• The FDIC insures up to $250,000 per depositor, institution, and ownership category. So, for instance, if you have a joint checking account, it would be insured up to $500,000. If you need to keep a balance greater than the limit (few of our clients do), consider spreading it over more than one bank.
• The FDIC does NOT cover mutual funds, stocks, bonds, money market funds, and other securities.

 For more details, we encourage you to consult the FDIC website. The bottom line is that banks are a safe place to store your cash, even if recent events remind us that they can fail. It is important to remember that bank failures, while typically rare, are a by-product of a functioning capitalistic economy. The chart below from the FDIC gives some historical context:

 Your Investment Accounts

Investors also have several layers of protection if the brokerage firm that holds their stocks, bonds, and mutual funds runs into financial trouble. The SIPC (Securities Investor Protection Corp) is a private non-profit corporation created by Congress for that purpose. Brokerage firms registered with the Securities and Exchange Commission (SEC), including those where your securities are being held (Schwab and Fidelity), must be members. The SIPC program, therefore, covers your securities. There are some crucial issues to understand about this coverage, though:

• It only protects investors in case of insolvency or fraud, NOT against market losses or bad financial advice.
• It covers investors for up to $500,000 in securities and up to $250,000 in uninvested cash.
• Different types of accounts are covered separately. For instance, your Roth IRA, traditional IRA, and joint account are all insured independently for a total of $1.5 million.
• It does NOT cover commodity futures, precious metals, currencies, shares in privately traded limited partnerships, or generally investments not registered with the SEC.
• Even though your assets may be protected if your brokerage goes bust, you may lose access to your funds temporarily while the SIPC takes control or transfers your investments to another brokerage firm.

Is it safe to keep more than $500,000 in one investment account? Fortunately, other layers of protection are available: First, the SEC has strict rules about segregating your investments from the brokerage firm. In a bankruptcy, the firm's creditors would have no claim on your assets. Second, brokerage firms, including Schwab and Fidelity, purchase "excess" coverage to significantly increase the amount insured in your account. This allows them to be more attractive to wealthy clients. Bottom line: we believe your family’s brokerage assets (and our own) are safe.

More information is available from Schwab,  from Fidelity, and on the SIPC website.

As always, we appreciate your trust in our services and welcome your comments, questions, and feedback.   

Now for some important housekeeping items:

IRS Extends Tax Deadline to October 16 for disaster area taxpayers.

According to this press release, disaster-area taxpayers in most of California (and parts of Alabama and Georgia) now have until October 16, 2023, to file their state and federal tax returns and make tax payments.

This means eligible taxpayers will also have until October 16 to make 2022 contributions to their IRAs and health savings accounts. The new deadline also applies to estimated tax payments.

Make sure to check first with your tax preparer if you are eligible, and whether you should extend. 

Disclosure Brochure Offer

Securities laws require Bristlecone to make available every year to clients the latest version of our disclosure brochure (Form ADV Part 2A). This form contains important information about our firm, such as services, business practices, potential conflicts of interest, a summary of our Disaster Recovery Plan, and Privacy Policy.

If you receive your 1st quarter statement by mail, a copy is included for your convenience. If you elected to receive your statements through our online portal, the disclosure brochure is available for download on our website by clicking here or on the U.S. Securities and Exchange Commission's Investment Adviser Public Disclosure website by clicking here, but we'll be happy to mail you a copy free of charge (call 310-806-4141 or email clientservices@bristlecone-vp.com)

You may find additional information about our firm on our website and through the same Investment Adviser Public Disclosure website at www.adviserinfo.sec.gov. We must also adopt a Code of Ethics and provide a copy to clients upon request. 

Contact us immediately if you have had any changes in your investment objectives or financial circumstances. Any changes could impact how we manage your portfolio and will become part of your client file. You should contact us anytime during the year if your investment goals or financial circumstances change. Should you hold equity securities in your portfolio, you will be responsible for voting proxies concerning those investments. We typically do not vote client proxies unless specifically requested.