Why Are The Markets So Strong?
Over the years, I’ve often commented that the market takes its marching orders from the economy. Typically, if the economy is doing well, the market is doing well. The reverse is also true, a poor economy usually means a poor market. So, the surge in the market over the past few months makes little sense to me. Since the end of March, the economy has taken a turn for the worse with over 30 million new unemployment claims. Yet, after an initial dip, the S&P 500 has risen to near record highs. How is it possible that in the face of a weak economy the market could be so strong?
There are three popular explanations for the strange behavior of the market. The first explanation, “don’t fight the Fed,” hangs on the belief that easy money is moving the market up. Chairman Powell recently indicated that the Fed is going to keep interest rates low for at least the next couple of years. While he didn’t address the stock market directly, both the Fed’s past behavior and its promise of low rates likely assure that stock prices are not going to fall. “Don’t fight the Fed” investors believe that the liquidity supplied by the Fed allowed the S&P to rise and will continue to drive stock prices higher. These investors are not concerned about the economy. Instead, their attitude towards the economy is summed up by Rhett Butler: “Frankly, I don’t give a damn.”
A second explanation about the relationship between the market and the economy notes that the job of the market is to assess future economic performance. The market should rise if it believes that the economy will be strong. Conversely, the market should fall if it believes the economy is going to be weak. Currently, the market seems to be saying that regardless of how heavily Covid burdens press upon us, before too long the economy will be humming and our current trauma will prove to be but a bump in the road.
A third alternative suggests that the strong market is due to the fear of future inflation. Inflation means that prices will rise, including the price of stocks. Why inflation? The lockdown has limited supply. For example, many beef processing plants are shuttered, limiting supply of beef. But because demand for beef has stayed constant due to paycheck protection and other government aid, retail beef prices have risen as much as 20%. Inflation has been defined as too much money chasing too few goods. Government relief programs have assured ample money, while lockdowns have hampered the supply of goods. Therefore, the rise in the market may be explained by the belief that prices will inevitably move higher.
Identifying which of these perspectives offers the best explanation of the bullish market will help guide our investment strategy. If we are just experiencing a blip, we can safely buy this market. But the other two alternatives suggest a more cautious approach. The lockdown has limited the supply of goods and services, which implies a sub-par economy. And refusing to worry won’t prevent the economic chickens from coming home to roost.
Right now we just don’t have enough data to forecast how this will all turn out. In my March comments, I suggested the best way to see what lies ahead was to construct two extreme scenarios. The optimistic scenario was similar to the “just a bump” explanation for soaring stock prices. The pessimistic scenario focused more on permanent damage to the economy stemming from Covid and the ensuing lockdowns. While neither extreme would likely occur, they would provide guideposts to give us a sense of whether we were headed in the “all clear” direction or the “danger ahead” direction. I also noted that it would be difficult to tell which path we were on until late summer or possibly even fall. By then, we will know if fewer restrictions and larger gatherings coupled with cooler autumn weather will bring a resurgence in Covid cases.
In a few weeks, public companies will start to report their earnings for the June quarter. These reports are expected to be awful. But investors will anxiously await word of more current developments: Is business picking up as restrictions are lifted? Is there enough visibility to reliably forecast earnings for the rest of the year? If management commentary is on the negative side, it will be hard to maintain an optimistic outlook.
For now, I believe caution is the most sensible approach to investing. The market is high and the way forward for the economy is unclear. We still don’t have our arms around the Covid pandemic. Until we do, we can’t really predict how fast the recovery will be. Other large questions remain. What will the ultimate impact be of our clamor for even more quantitative easing? Can the government continue printing money with no consequence? Will we ever have to pay for this unbounded generosity with higher taxes or higher inflation? There are many questions but few answers. While FOMO (fear of missing out) prevails among investors, a more conservative approach will preserve dry powder as these questions get sorted out.
To close on a more positive note, I want to call out the performance of our World Innovators Fund (WAGTX). As of June 30, our fund is up 12.21% for the year.
| As of 6/30/20 | 1 Month | 3 Month | YTD | 1 Year | 3 Year | 5 Year | 10 Year |
|---|---|---|---|---|---|---|---|
| WAGTX | 6.88% | 48.00% | 12.21% | 19.39% | 11.58% | 10.49% | 13.29% | MSCI ACWI IMI ex. USA Small Cap Index | 3.26% | 22.83% | -12.80% | -4.34% | -0.17% | 2.50% | 6.05% |
*the MSCI All Country World Index Ex-USA Small Cap is a commonly used international small cap benchmark
Data shows past performance. Past performance is not indicative of future performance and current performance may be lower or higher than the data quoted. For the most recent month-end performance data, visit www.sevencanyonsadvisors.com. Investment returns and principal value will fluctuate and shares, when redeemed, may be worth more or less than their original cost. The Advisor may absorb certain Fund expenses, leading to higher total shareholder returns. The Advisor has contractually agreed to reimburse Total Annual Operating Expenses in excess of 1.75% and 1.55% for the Investor Class Shares and the Institutional Class Shares respectively until at least January 31, 2021. This agreement is in effect through January 31, 2021 and may only be terminated before then by the Board of Trustees and is reevaluated on an annual basis.
As always, we appreciate your confidence in Seven Canyons. We are grateful for your willingness to invest alongside us as we hope for the best, but prepare for the worst.
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.
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