Business as Usual… With Two Potential Disruptions
Dear Fellow Shareholders:
Despite the frightful headlines (trade war with China, failure of N. Korean treaty), I expect the economy to continue its slow growth of the past decade.
While the market has been much more volatile than the economy, moving forward in fits and starts, it too has continued to move up and to the right over the past decade. My mantra is that the economy drives the market. As long as the economy keeps giving positive cues to the market, I expect the market to continue to be healthy. There are, however, two possible disruptions to this otherwise sunny scenario.
The first has to do with the rise of automated trading, including the growth of Exchange-traded funds (ETFs). According to one estimate, 25% of all trading is driven by algorithms, and an additional 50% is driven by “automatic” ETF transactions. This means that instead of market prices being determined by the interaction of human buyers and sellers, they are increasingly determined by the interaction of computers. Many have debated the significance of this shift in how market prices are determined. No conclusive answer has been reached. However, there are numerous examples of the short term impact that such robotic trading can have on the market. The first episode was the 20% one day market tumble in 1987 driven by automated program trading. Prior to the decline the economy was displaying some warning signs, but on balance it was fine. Despite the mid-year market hiccup, Gross National Product (GNP) grew and the market returned over 5% for the year.
A more recent example was the “flash crash” of 2011. Within a few minutes the market fell by 5% only to recover minutes later. It was far worse for some individual stocks, which plunged 20% and then bounced back moments later. Both the program trading induced decline of 1987 and the flash crash are example of clear air turbulence. Some of you may have experience such an episode in an airplane which is flying smoothly in calm air but then suddenly drops by hundreds of feet. That experience is disturbing but only lasts for a few moments. Soon the plane is again flying smoothly thru calm air. Similarly these disconcerting market panics last only a short time before the market reverts to normal.
My concern is that the increasing automation of the market price setting function will lead to further instances of clear air turbulence. For example, last year we had two examples of clear air turbulence affecting the market. For both episodes, the backdrop was a reasonably well behaved economy. Near the end of January the market started to drop. Within a few days it had fallen 10% and most of the FANG stocks fell by 20% or more, though they fully recovered later in the year. While this episode hasn’t been officially linked to automated trading, the swiftness and severity of the decline were unusual and likely reflective of automated trading. Similarly, in December the market plunged 15% before it reversed, fully recovering its loss in the early months of this year. Again, there was been no official linkage to automated trading, but it is almost certain that clear air turbulence was at play.
Why is this a concern? Take the market crash of ‘08 as an example. Arguably, clear air turbulence played a role. But woe to those investors (like myself) who treated the initial decline as an opportunity to buy the dip. The initial decline proved to be but a preview of the real deal. The early drop led to a full scale market rout and a global financial crisis (GFC) as 2008 wore on. This is because there were serious economic problems emanating from the financial sector.
The second potential disruption stems from the unanticipated consequences of the never-before-tried monetary policy implemented post the GFC. For years, economists have offered the same prescription for treating an economic decline severe enough to induce panic in the markets: Quickly use monetary policy to quell the panic, and then implement fiscal policy to salve the economic wounds. Post the GFC, the first leg of the prescription was implemented and monetary policy curbed the panic. But when fiscal policy proved restricted in scale, authorities chose to continue their easy money policy well after panic had subsided.
While the Fed is solely responsible for monetary policy, fiscal policy is a group project involving the president and both houses of congress. Fiscal policy was especially complicated as we were in the midst of an election in the fall of ‘08 while the markets were coming apart. Ultimately some fiscal actions were implemented, but they were limited in scope. Impatient policy makers continued to rely on monetary policy rather than roll up their sleeves for the hard task of implementing appropriate fiscal policies such as tax cuts. Only when Trump was elected and the economy had fully recovered were tax cuts implemented. Many believe that these cuts came so late in the economic cycle that they were inappropriate.
As the Fed tries to unwind the enormous amount of easy money, the nature of its dilemma is becoming clear. The Fed was able to implement several rate hikes with the goal of forcing rates to a level reflective of the state of the economy. Before the Fed was able to accomplish this goal, market weakness led them to back down. The goal of the monetary policy post the GFC was explicitly stated as forcing money into risky assets to stimulate investment. While this generally worked to a degree, the dominant effect was to increase the price of risky assets such as stocks. Now fear of falling asset prices may hinder effective monetary policy. We are in no man’s land. Nobody really knows the ultimate impact of normalizing our monetary policy.
Putting this all together, we have a sunny scenario with two potential disruptions. How significant are potential disruptions? No one knows. But investors whose optimism stems from a strong economy should be aware of disruptions which could lead to market weakness in spite of the steady economy.
SEVEN CANYONS UPDATE
It has been a busy first quarter at Seven Canyons Advisors and an exciting start to 2019. Perhaps the most exciting news is that for the second year in a row we were honored with a Lipper Fund Award. We also received the Investor Business Daily Best Mutual Funds Award for International Stocks. The news of both awards is an exciting recognition of the strategy and work that have gone into finding the best companies around the globe.
Our office is growing. We added two new employees to assist in our efforts to communicate to current and potential investors as well as to provide additional operations support to our investment team. Andrew Harvey and Andy Zhang (affectionately called “The Andrews”) provide additional experience and knowledge that will help the team operate more efficiently.
Finally, we continue to scour the globe for great companies to invest in. Spencer spent time in France and Turkey in January, and Wes just returned from a conference in Dubai followed by a weeklong trip visiting companies throughout India. Wes reports that in addition to seeing many great companies, it was an exciting cultural experience as he shared a desk at the Dubai conference with a lady wearing a niqab – confirming that we truly are a global community.
In closing, I want to tell you how much I appreciate your willingness to invest alongside us in our Seven Canyons World Innovators (WAGTX) and Seven Canyons Strategic Income (WASIX) funds. I look forward to a profitable future together.
Sam Stewart, Partner
FANG Stocks – Facebook, Amazon, Netflix and Google (now Alphabet, Inc.) stocks
Investor Business Daily Best Mutual Funds Awards – The 2019 award winners were drawn from a universe of 3,081 mutual funds that met the criteria of having at least $100 million in assets and 10 years of operation. The awards span 13 categories and subcategories. The largest category, U.S. Diversified Stock Funds, is also broken down into the subcategories of Growth Funds, Blend Funds, Value Funds, Large-Cap Funds, Midcap Funds and Small-Cap Funds. Other categories are Sector Funds, International Stock Funds, U.S. Taxable Bond Funds, International Bond Funds, Municipal Bond Funds and the new Index Funds category. As in 2018, no value funds made the 2019 list. The funds are ranked according to their 10-year performance.
The Lipper Fund Awards program honors funds that have excelled in delivering consistently strong risk adjusted performance, relative to peers. Lipper designates 2018 award-winning funds in most individual classifications for the 3, 5, and 10-year periods ending November 30th of 2018. The World Innovators Fund competed with 17 Global Small-/Mid-Cap Funds over the 10-year period to win the award. Lipper Award designations are not intended to constitute investment advice or predict future results and Lipper does not guarantee the accuracy of this information. In addition to periods of positive returns, the Wasatch/Seven Canyons fund that received a Lipper Award has experienced some periods of negative returns during the award time frame. Past performance is not indicative of future results.