Why bank failures didn’t crash the stock market

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Did someone forget to tell the stock market about the stock market crash? Amid a string of bank failures and bailouts this year, the S&P 500 index has somehow crept up nearly 4%, not counting dividends.

I suppose we can call that a rebound from last year’s 20% price drop. On the other hand, the valuations don’t look particularly erratic. The index is trading at an ambitious 18 times this year’s forecast earnings.

Where’s the gnashing of teeth and despair? Except on Twitter, I mean.

Bears say reckoning is near. Earnings estimates appear increasingly unrealistic, wrote

MorganStanley

Equity strategist Mike Wilson in a Monday report. Price-to-earnings ratios could fall “steep and unexpected”. And the recent underperformance of small-cap and low-quality stocks means it’s imminent, he says.

Goldman Sachs
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on the other side predicts a stall but no slip.

S&P500

Earnings will rise 1%, slightly beating the consensus estimate, and the index will end the year at 4,000 points, a fraction of a percent above its recent level, the bank argues.

But what about the looming lending freeze, with banks, many spooked by deposit losses, becoming tight on credit, hurting the economy? A new report by top Goldman economist Jan Hatzius lays out the case for not worrying.

The probability of a recession within the next 12 months has increased, but only from 25% to 35%, well below the consensus of 60%, according to Hatzius. Conditions now look better than they did before a painful, bank-driven recession 15 years ago, for four reasons.

First, lending already looks lean: Banks have tightened lending since the middle of last year. Second, large banks in particular, which have higher liquidity standards than small ones, are unlikely to further reduce lending.

Third, this crisis, triggered in part by banks’ losses on their government bonds, has pushed investors into the same government bonds, driving up prices and reducing paper losses for lenders. This is the opposite of what happened in 2008, when assets at the heart of the crisis continued to depreciate.

Fourth, commercial real estate, a large source of credit demand for small banks, was already struggling, so lower credit supply there might not have much of an impact.

All of this leads Hatzius to predict that the current banking crisis will be “headwinds, not hurricanes.” Maybe it’s safe to put out my patio furniture.

Some caveats: The economy is not the same as the stock market. Stock prices can fall in the short term with or without a recession.

Besides, I don’t know who’s right. I’m not good at predicting the timing of recessions, bank runs, or stock market crashes because those things depend on human behavior. While you are personally a monument to stability, dear reader, consumer, depositor and investor, everyone else is moody. Just between us.

My best guess is, pretty much always, that the things that usually happen will happen now. Stocks don’t usually crash. Banks don’t usually fail.

The tricky part is that there’s a non-negligible chance that weird and decidedly bad things will happen instead. So make sure you have a generous mix of bonds in your portfolio, including short safe bonds.

The good news is that Treasury bills are still paying around 4.9%. They returned over 5% earlier in the month, but they returned less than 0.25% early last year.

Write to Jack Hough at jack.hough@barrons.com