We have just come to the end of another quarter and things keep rolling right along. As expected, we had another interesting quarter with much excitement along the way. After a bang up first quarter, we rolled on into April and May with a string of ever higher closes week after week. We finally peaked at 1669.16 in mid-May before the market paused to catch its breath. By late June, we got word from the Federal Reserve that their quantitative easing program – their addition of cash into the banking system via bond purchases – was not going to last forever. This spooked the markets for a week or so as interest rates spiked a bit and stocks sold off. However, things began to recover towards the end of June as reality began to set in that a strengthening economy was probably not such a bad thing after all.

The big news as we head into the second half of the year is the Fed’s tapering – eventually. Everyone knew it had to come. It was always a question of “when” not “if”. Until the June Fed meeting, the timing was left very open-ended with a ‘we’ll taper when unemployment reaches an acceptable level’ type of talking point. After the June meeting, Fed Chairman Ben Bernanke stated the Fed could start tapering “within the next few meetings” which would indicate towards the end of this year or early next year – not a surprise to most everyone. However, this news sent shivers through the markets as interest rates popped and stock prices fell. Here is why both happened…

If the Federal Reserve reduces the amount of bonds they purchase, this has two effects. One is to reduce the amount of cash going into the monetary system (i.e. our economy). The second effect is to raise interest rates and this is what chilled markets. If interest rates rise, newer bonds with higher coupon rates (i.e. interest rates) will be more attractive than older bonds with lower coupon rates. Markets tend to be forward looking, so with traders anticipating rising interest rates, they sold bonds, especially Treasury bonds that, while safe, tend to have the lowest interest rate. If you can purchase a safe Treasury bond that guarantees you 4 – 5% interest, you are more likely to do that than to purchase a stock that pays a 2% dividend and offers up the chance to earn 6 – 7% but with a lot more risk involved. It comes down to a question of a safe 5% versus the possibility of 8 – 9% but with a lot more risk and even a good chance at losing some of your principal. Many investors – retirees, especially – would prefer the safety of the higher yielding bonds.

So where does that put us? We have been gradually adding stocks that either are immune to interest rate increases or my benefit from this increase in rates. We have added UnitedHealth Group (UNH), a health insurance company that could be a beneficiary of the implementation of the Affordable Health Care Act (aka “Obamacare”). In addition, UNH will benefit from the aging population as one of the top providers of supplemental Medicare insurance. We have also followed Warren Buffett into one of his long-time favorites as we have added shares of Wells Fargo & Company. This is currently one of the best run banks in the country, having steered clear of any controversy during the financial crisis and even stepping in to rescue Wachovia Corp, which was a victim of overreaching, bad management and too many bad mortgages on their books.

We have also been looking at reducing some of the risks in the portfolios, having sold off all of our holdings in one bond fund, the iShares Barclays TIPS (TIP). We eliminated this fund largely because of price risk – the share price of this Exchange Traded Fund (ETF) was falling and, with no catalyst for inflation on the horizon, there was nothing to entice buyers to this fund. We also eliminated our holdings in Sensient Technologies as we felt this stock was getting ahead of itself on a valuation basis.

Going into the second half of the year, while the Federal Reserve’s QE program will still act as a support to the markets, we think there is going to be an increased focus on company fundamentals and growth as the economy continues to inch forward ever so slowly. We do see one big cautionary note. A recent report from financial publisher Thomson Reuters noted that 93 companies in the S&P 500 index have issued negative preannouncements to their upcoming quarterly earnings report versus only 14 companies with positive announcements. Why is this significant? This is a much higher ratio of companies with bad news than is common. Typically, we see a ratio of 2.4 companies warning investors ahead of time for each company that cannot wait to brag. This quarter, the ratio is over 6.6 times (see the article here). This is a little bit worrisome and may be indicative of the economy running out of steam for the moment. This is partly why we have been a bit more cautious of late and still hold a fair amount of cash in client accounts. If the volatility we expect does materialize, we anticipate taking advantage of this situation by adding some new positions to client accounts.

And, as always, we truly appreciate the trust you have placed in us and the opportunity you have given us to manage a portion of your assets. If you have any questions or need to discuss any issues please feel free to give us a call.

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