This past quarter brought back a long-lost friend to the investing world – volatility.  We saw the S&P 500 Index try to break out to new highs  before dropping nearly 6% in early February, then climbing to new highs in early March before backing off a bit to close up a measly 1.3% for the quarter.  There were several key reasons for this volatility.  These included the Russian invasion of Crimea, the lackluster earnings reports from companies reporting year-end results, the continued weak jobs recovery and the incessant snows that seemed to occur week after week, slowing consumers and prompting many companies to forewarn of weakened earnings this quarter. In fact, we have had a few companies (very few) start to report first quarter earnings and the trend is not good, so far, with almost half reporting earnings below expectations. 

In looking at where we currently stand, it would seem that stocks might be a bit overvalued.  One of the newest “toys” that I have found to play with is something called the CAPE ratio – cyclically adjusted PE ratio.  Dr. Robert Shiller of Yale University developed this measure.  It is essentially the current price of the S&P 500 index divided by the average, inflation-adjusted earnings over the past ten years.  Currently, this number is a bit above “normal”, which would flash a caution signal.  So does this mean that we should sell everything and retreat for cover?

The short answer is “no”.  Just because the market is overvalued, does not mean that every single stock is overvalued.  In fact, most of the stocks and portfolios that we have created for clients are not highly correlated with the market.  What that means is that when the broad stock market zigs, we don’t tend to zag along with it or nearly as much.  Instead, we tend to fall less than the broad stock market.  Much of this is due to our attempts at risk control.

Let me explain a bit further.  As many of you are aware, we had a stock blow up on us this past quarter.  We came into the year with a number of clients owning shares in an oil pipeline company called Boardwalk Partners.  When Boardwalk reported their 2013 earnings, they also dramatically cut their dividend.  We had expected a potential cut in their dividend of ten cents or so from the $0.53 per share they were paying.  Instead, they cut the dividend TO ten cents per share!  This took us completely by surprise.  It did not just surprise us.  Several other well-respected analytical agencies (Morningstar, for instance) were also caught completely off guard.  The stock price plummeted and we bailed out of our shares.  We lost all faith in management to provide adequate guidance or leadership.  In spite of this setback, almost every account showed gains for the quarter with most accounts even beating the broad stock market.  Many of the accounts that simply matched the index performance were holders of Boardwalk shares.  We would attribute this ability to earn positive returns even in the face of adversity to our risk control for clients.  So we return to the question at hand and reiterate that we do not think there is any need to sell out of stocks in spite of the broad market risks. 

This does not mean that we will not sell anything.  In fact, during the quarter, we did selectively take profits on stocks that have done well, selling out of some shares of TESSCO Technology (TESS), for example.   This stock had grown to an uncomfortable level in many accounts.  By selling some shares, we added cash to client accounts and reduced client risk.  We will continue to monitor holdings for advantageous opportunities such as this.

While it may seem counterintuitive, we would actually welcome a bit more volatility.  As I mentioned above, we currently see the broad stock market as relatively fairly valued, if not a bit overvalued. This plays out in our not being able to find good buying opportunities.  With increased volatility and the potential for market pullbacks, we would expect to have bargains presented to us.  We have a shopping list ready but we are just awaiting the right price for some of the names on our list. 

One last thing that I wanted to touch on was a recent report that many of you saw on the CBS News program “60 Minutes”.  The segment included an interview with noted author Michael Lewis about a new book he has just released titled “Flash Boys”.  The book was about something called “high frequency trading”.  Several of you have asked me if this high frequency trading or HFT affected us.  Indirectly, yes.  The way we see this played out is in the price that we pay.  What happens is that we enter an order to buy, say 5,000 shares of XYZ Company stock at a maximum price of $54.50 per share.  Some HFT firm will see that order before it actually gets to the exchange because they have a faster computer than anybody else.  This trader will then step in, buy 5,000 shares of the stock for $54.495 per share, then turn around and sell it to us for $54.499 per share.  Now, on the surface of it, we came out a bit better by 0.001 cent per share.  However, this is not necessarily fair.  Why were we not given the opportunity to purchase the stock for $54.495 per share?  Prior to HFT’s, we might have had the opportunity.  This is what Michael Lewis was talking about when he was saying that the markets are rigged.  The answer to this problem is actually an easy one – restrict high frequency trading.  The stock exchanges sell the rights to get quotes faster to these traders and the SEC can restrict the exchanges’ ability to do this.  But that is a topic for another discourse.

As always, we do truly appreciate the trust that you have placed in us with 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
(410) 864-8746
(866) 857-4095