Wow!  What a quarter we’ve had!  As the quarter started off, the U.S. was embroiled in a debate on whether and how to raise the debt ceiling.  If you recall, the U.S. needed to raise the debt ceiling in order to meet obligations we had already committed to spending.  Many on the far right of the political spectrum were refusing to raise the debt ceiling and, going a step further, were calling for cutting spending by dramatic amounts.  In my last newsletter, I wrote about the debt ceiling debate in the second quarter letter which you can read in our blog: http://www.aeriecapitalmgmt.com/news/.

We actually set up clients well for the impending vote on raising the debt ceiling.  We were anticipating we might run into a situation similar to the first TARP (Troubled Asset Relief Program) vote in September 2008.  When that program first came up for a vote, many in Congress didn’t want to bail out the banks.  When the vote failed, the Dow Jones Industrial Average dropped over 700 points in minutes.  About two weeks later, the vote came up again and passed, but the damage was done.  Going into the debt ceiling debate, we purchased some options in client accounts that would gain in value if the markets fell.

While the debt ceiling was raised with little trouble, that does not mean that all went smoothly this past quarter.  Much to the contrary, this was a very tough quarter for the markets.  In spite of raising the debt ceiling, major credit rating agencies cut their credit rating on the U.S. for the first time ever.  Turmoil was not restricted to just the U.S. markets, however.  There were continuing troubles in Europe as Greece continued to threaten to default on their debt, French banks ran into troubles from their exposure to Greek debt giving us the threat of a French version of Lehman Brothers – the U.S. investment bank that went bankrupt in September 2008 triggering the credit crisis – and China’s growth rate showed signs of slowing down.

All of this made for some very wild swings in our markets this quarter.  As an example of how volatile things were this past quarter, we had more 200-point swings in the Dow Jones Industrial Average (i.e. either closing up or down by 200 or more points) than any quarter since early 2009.  In fact, during the second week of August, the Dow closed up or down by more than 400 points on four of the five days that week – closing up only 125 points on Friday!  Does anybody have anything for motion sickness?

Out of all of this volatility, we ended up with the markets essentially trading within a broad range.  For most of August and September, we stayed within a range that bottomed around 1,100 (using the S&P 500 Index) and 1,220 on the top end.  This roughly corresponds to 10,600 and 11,750 on the DJIA as the range.  We tested the lows of this range on six separate occasions in August and September carrying on into the first week of October.

We tried to use this volatility to our advantage, but frankly, we feel like we missed it on this one.  While that is not entirely true – borne out by the fact that most client accounts fell far less than the broad market did for the quarter – we still feel like we could have done a better job.   We entered trades to purchase put options – options that benefit from falling markets – on three separate occasions.  The first time paid off handsomely, but the next two times, not so much.  We only entered these trades, though, when it looked like markets were in danger of completely melting down.  Rather than view these as bad trades, we prefer to view them as insurance premiums paid to insure against a catastrophic loss.

In addition to these option trades for insurance purposes, we made a few additional equity trades along the way.  We added Johnson & Johnson (JNJ) to many portfolios as the stock dropped to a price that essentially assumed the company would never grow at all.  Since we clearly think that JNJ has the ability to continue to grow, if even at a modest rate of inflation, and since we were getting a dividend yield comfortably above 3.5%, we were happy to add JNJ to accounts.  We also bought more ConocoPhillips (COP) for clients – adding this as a new position in a few client accounts and cost averaging down in some other accounts.  With COP, we managed to purchase shares at a price that provided a 4% dividend yield.

On the downside, we didn’t take advantage of the dips as much as we would have liked to, in retrospect.  While much of what was going on was very headline-driven, we did see reasons to worry.  There were comparisons of this year to 2008, often unfairly.  The comparison was of Europe and the European banks today with our banking system in late-2008 just before Lehman Brothers declared bankruptcy and credit markets ground to a halt.  The big fear was that Greece would default on their debt, leaving European banks, mainly in France, holding the bag with a lot of worthless debt.  This would make these banks insolvent, ruining the credit markets around the world.

While this was a worst-case scenario, there were enough signs of market uncertainty and risk that we chose to be more cautious with client funds.  Instead of wading in to the bloody mess and snapping up stocks left and right, we chose to take profits when we reached the top of our trading range and opting mainly to remain in cash.  This higher cash balance – often approaching a third or more of accounts – helped reduce the volatility a bit and kept the losses for the quarter from being worse.  While we may have dampened gains down the road, we also limited losses, which we view as our primary job.

Going forward, we feel like we are positioned well.  We have higher cash balances at the moment but we also have a good list of stocks that we want to purchase and prices that we are willing to pay for shares of these companies.    We are not going to ‘chase’ stocks.  We’ll continue to do what we’ve always done.  That is, we’ll look for good companies trading at great prices with a margin of safety to protect us.  When we get more volatility – and we will – we’re ready now to wade into the fray and selectively buy some good names.

As always, we recognize that you have many choices when it comes to your money.  We really do appreciate the trust you have placed in us by letting us manage a portion of your assets.  If you have any questions or concerns, please do feel free to give us a call.

Sincerely,

Alan R. Myers, CFA
President / Senior Portfolio Manager
Aerie Capital Management, LLC
(336) 306-5496
(866) 857-4095