With apologies to The Fifth Dimension (and, at the risk of dating myself), up, up and away in my beautiful, my beautiful…bubble? As the market has continued its inexorable climb the overarching question seems to be how much further can we go. After all what can go wrong? The only risks we currently face are military situations in Eastern Europe… and the Middle East…and China’s slowing economy…and oil prices rising…and, well, you get the idea. In spite of this great wall of worry, the long-term outlook for the U.S. economy is positive. Earnings expectations are for 4% growth per quarter for the next several quarters for the S&P 500 companies. The stubbornly high unemployment rate is slowly creeping downward. The best measure of the unemployment rate is not the officially announced number of 6.1% at the end of June, but is probably a number officially known as the U-6 rate. This rate measures all those unemployed plus those marginally employed (part-time work because that is all they can find) plus all those that have dropped off the official unemployment rolls but are still actively looking for work. This number currently stands around 12.1% of the labor force but that is down significantly from the 17.4% rate in October 2009. Prior to the 2008 financial crisis, the long-term average for this measure was around 9%, so we are slowly creeping close to normal.

The truth is we probably have more room to the upside, though I will readily admit that stocks are getting pricey. As you may recall from my last quarterly letter, one of my new “toys” for evaluating the overall health of the market is the CAPE ratio – the cyclically adjusted P/E ratio. This ratio stood at 21.29 times operating earnings as of the end of the first quarter, which was a small drop from the year-end number. While this may seem high, the average of this ratio since 1998 has been around 23 times operating earnings. This would argue that we still have a little bit of “wiggle room” for stocks to continue higher.

Regardless of what ratios may indicate, there is still a real danger of stocks being in a bubble. There has been much talk and speculation about that very topic. If you search “stock market bubble 2014”, you get something like 52 million hits. The list of articles include everything from predictions about when the bubble will burst (assuming we are in one, of course) to how to protect yourself from the bubble bursting to articles debunking the bubble idea. The simple truth is stocks may be a bit ahead of themselves largely because they are the only game in town. The Federal Reserve has worked to drive down interest rates, which makes bonds a terrible investment currently. The key reason for the low interest rates has been to entice businesses to invest. If borrowing costs are low, businesses should be eager to borrow money to invest in new property, plant and equipment. However, that is just not happening and one side effect has been to drive investors into more risky (read: stocks) assets. This has sustained the stock market’s rise. The argument is that when interest rates start to rise, money will come pouring out of stocks and into bonds which tend to be safer investments, thus bursting this investment bubble. This argument has some merit. The key issue, though, is timing. When will interest rates start to rise? How quickly will they rise? How quickly will investors shift their investment choices from stocks to bonds?

With no clear-cut answer to these questions, we fall back on an old Wall Street maxim – never fight the tape. That is, when momentum is moving in your favor, you do not try to move in the other direction. One good way to do this is to use technical analysis to help make decisions on when to buy and when to sell. I recently read a couple of articles published by a former business school professor of mine. He has done some work on technical analysis – specifically a naïve measure called a “simple moving average”. His conclusion is that using simple moving averages has the ability to capture trends. In other words, you can “see” when a stock is going up and when it might be going down and take appropriate action based on the moving average. Actually, the idea of using moving averages is not new. In fact, some of the most successful commodity traders of all time use technical analytic tools such as moving averages to choose when to buy and when to sell.

We employed this strategy this past quarter. One of our holdings, TESSCO Technologies (TESS), had fallen below the 200-day moving average, thus signaling future weakness. We had already sold some shares in the first quarter of this year as the stock had run up tremendously, but based on this new information, we sold out of the stock completely. It turns out that we have been right, as the stock has continued to lag the market since we sold.

Many of you may have noticed a relatively new mutual fund appearing in your accounts. I am slowly moving cash into a mutual fund that invests in “floating rate loans”. Floating rate loans are senior loans to corporations that adjust their interest rate periodically. These loans are typically a great investment during a rising interest rate period. The mutual fund we are using, the T. Rowe Price Floating Rate fund (PRFRX), has a current yield of just over 3.5% and we can trade it with no fees as long as we hold it for at least 90 days. This is why we are scaling in to the fund. Eventually, this will be where we park our cash in client accounts. That way, clients will earn something rather than nothing as most cash holdings currently earn. There may be a little bit of cash left in some accounts to allow for selective opportunities that come along but the tendency will be to invest as much of the cash as possible.

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.

Sincerely,
Alan R. Myers, CFA
President / Senior Portfolio Manager
Aerie Capital Management, LLC
(410) 864-8746
(866) 857-4095
www.aeriecapitalmgmt.com