Congestion

CONGESTION

Over the past five years the S&P 500 has risen sharply, producing a 15.2% CAGR (far above the 9.6% long-term average market return). Following this extraordinarily strong performance, the market seems to have entered a period of congestion. In recent months, the market stopped rising and has flattened out, with not much movement in stock prices or trading volumes. This narrow fluctuation of prices and trading volumes is referred to as congestion–a market where buyer’s demand to buy stocks is matched by the seller's supply. Hence, prices and volumes don't move much.

It is no wonder that investors seem to be pausing to catch their breath. The market has risen nearly 90% since its initial plunge during the early days of Covid’s economy-threatening lockdowns. Congestion suggests that investors see a murky future. That is, investors are uncertain about the future course of the stock market and, by inference, the economy.

Some glass-half-empty investors focus on negatives which limit their buying enthusiasm. Top of mind for these investors is uncertainty about how the economy will perform as stimulus is withdrawn. If government stimulus has been supporting the economy, what will happen when the stimulus ends? Won’t the economy weaken? Also, how will we deal with the $3 trillion deficit (15% of GDP) and pay our resulting massive debt?

Another concern for pessimistic investors is inflation. As I discussed in my comments last quarter, 20% of all dollars ever created were created by the Fed last year. Nobel Prize-winning economist Milton Freidman famously stated, “Inflation is always and everywhere a monetary phenomenon.” Per recent reports, all of the recently created money poured into the economy has led to sharply increasing prices. Current inflation is stronger than it has been in years.

Even our weather patterns feel foreboding. I have a ranch in central Utah. None of us old hands could recall a drought as severe as that of last summer. Yet the weather this year is even worse, featuring not only high temperatures, but also high winds. Many farmers are not even bothering to cut their hay, as the crop is so poor. And Central California, the fruit basket of America, is experiencing ever-worsening drought. Unsurprisingly, feed and food prices are soaring.

Political division in the US (and to varying degrees throughout the world) also has investors worried. This bickering reduces the effectiveness of our government. For example, President Obama’s administration implemented several key changes, notably among them health care policy and our stance toward our global neighbors. President Trump worked to replace President Obama’s policies. Now, President Biden is undoing some of President Trump’s policies. What a mess! Only 30% of Americans approve of how our government is functioning. How can this turmoil be good for the economy or stock market?

While many investors resist buying due to these negative factors, other investors see the glass as half full, so they resist selling. It is the balance between pessimistic and optimistic investors which creates congestion in the stock market.

What do glass-half-full investors see?

First and foremost is the strength of stock prices, which have risen nearly 90% off the bottom, and over 30% since the pre-Covid beginning of 2020. Yes, there was a sharp Covid dip. Even so, the 15% per annum increase experienced from 2015 to 2020 seems firmly in place as the market returned more than 18% last year and over 14% this year. Glass-half-full investors believe that the market will exit this period of congestion by breaking out to the upside.

A second reason for optimism is that recent government largesse can be seen as pump priming. While not many of us have primed an actual pump, most have used lighter fluid to get barbecue briquettes burning. Once the briquettes are ignited, lighter fluid is no longer required. This helps us understand how the economy can continue humming even when government stimulus is not continuously supplied. Of note, the unemployment rate has fallen much faster than expected: from a Covid peak near 15%, to a current rate near 5%. Plentiful help wanted signs suggest there is more employment good news to come.

Nor do optimistic investors fear surging inflation, as they believe it will prove to be transitory. Japan presents an example of why this may be true. For many years Japanese monetary authorities have tried to generate inflation, but have had only limited success. Japanese inflation climbed as high as 1.5% in 2018. But recently Japan has been experiencing deflation, with prices declining 0.4% in the latest report. Japan suffers from the twin weights of demographics and debt. While the US has a notably younger population and much less debt, we appear to be following in Japan’s footsteps.

One positive outcome of Covid has been an acceleration in productivity, which is an antidote to inflation. Covid adaptations revealed the benefits of working remotely. Many have found that the hardships of commuting exceed the distractions of working from home. We have become more productive by not going to the office on a daily basis, to say nothing of the productivity enhancements of more flexible work hours, efficient use of technology, and fewer cars on the road.

Workplaces are not the only areas of increasing productivity. Developing renewable sources of energy promises a more productive future. Yes, constructing hydro, wind power, and solar energy sources requires abundant up-front capital expense, but their ongoing maintenance expense is substantially lower than the ongoing fuel costs of coal, gas, or nuclear. As we move towards renewable energy, not only do we become a greener economy, but we also become a more productive economy.

OUTLOOK

As always, there are pros and cons to be considered in assessing the future of the market. Whenever the outlook seems obvious, the market is priced accordingly. For example, as Covid fears ran rampant, the market fell by more than 30%. Had this rate continued for an entire year, the market literally would have been worth next to nothing. The subsequent surprising 90% increase in stock prices shows that investors can misread the tea leaves. From time to time, I’ve certainly been guilty of that. But for now I stand with those who believe that the crosscurrents in the economy will keep prices relatively flat for some time to come.

Even so, it is worth reminding ourselves that the stock market is actually a marketplace of stocks. Some stocks will fall during the best of times. Others will rise during the worst of times. At Seven Canyons we hang our hats on our ability to ferret out stocks which we believe can do well in any market environment.

Thank you for investing alongside us as we work towards our goal of searching for undiscovered companies with great management, a competitive edge, and a long runway to grow.

Sincerely,

Sam Stewart,

Partner

This letter is for informational purposes only and does not constitute investment advice or a recommendation of any particular security, strategy, or investment product. The expressed views and opinions presented are for informational purposes only, are based on current market conditions, and are subject to change without notice. Although information and statistics contained herein have been obtained from sources believed to be reliable and are accurate to the best of our knowledge, Seven Canyons Advisors cannot and does not guarantee the accuracy, validity, timeliness, or completeness of such information and statistics made available to you for any particular purpose. Past performance is not indicative of future results.

Chairman's LettersSam StewartJune 30, 2021