This was a moderately tough quarter and not just in the markets.  The U.S. is once again embroiled in a conflict in the Middle East with ISIS, which is a new terrorist group in Syria and Iraq.  The Ebola virus is spreading in central West Africa and only recently entered the U.S.  We saw falling oil prices largely driven by a strengthening U.S. dollar (oil is priced in U.S. dollars around the world, so if the dollar is stronger, it takes fewer dollars to buy the same amount of oil).  Europe is in the midst of a recession and their version of quantitative easing.  Meanwhile, our Federal Reserve continues to taper its bond-buying program, which has led to increased stock market volatility.  In spite of all of this uproar, the broad indexes seemed to paint a picture that all is right with the world.  The Dow Jones Industrial Average and the broader S&P 500 Index both ended the quarter with modest gains.  But was this reality?

Oftentimes, we talk about stocks based on their ‘market cap’ or market capitalization.  What we are referring to is the market value of all of the shares outstanding for a company.  Typically, analysts and financial advisors will segment stocks into small capitalization stocks (small cap), mid-cap stocks and large cap stocks.  There is no hard and fast rule for what constitutes each area.  A good rule of thumb would be that a small cap company has a total market capitalization of less than $2 billion, a mid-cap company would have a market capitalization between $2 billion and $6 billion and a large cap company would be worth more than $6 billion.

What does this have to do with us?  Well, it has a lot to do, actually.  While the broad indexes were up slightly for the quarter, if you dig beneath the surface, you would find a very different picture.  In fact, while the Dow and the S&P 500 indexes were up, these indexes tilt heavily towards large cap stocks.  Mid-cap stocks actually fell 4.33% and small cap stocks fell 7.65% for the quarter.  This did not help, as we tend to lean more towards the mid-cap and small cap space for investment ideas.

We still had a reasonably good performance, in spite of the tilt towards the more volatile small and mid-cap space.  There were some accounts that showed small losses for the quarter, but we do not worry about a single quarter.  You can also rest assured that I am not sitting by, idly twiddling my thumbs or singing Monty Python’s “Always Look on the Bright Side of Life”.  I have been actively seeking ways to minimize losses while keeping us invested as much as possible.

In addition, as I mentioned near the top of the letter, we are seeing more volatility due to the QE program ending.  In the past, whenever there was a small dip in the stock market, buyers would step in.  The investment world was awash with cash from this bond-buying program.  With the tapering of the quantitative easing program, the amount of cash to flow into the stock market is reduced which is likely to lead to greater volatility – or, actually, a return to more normal levels of volatility that we have forgotten about.  This may mean we do a bit more trading than we have done in the recent past.  However, this will also create opportunities for us, but that does not mean that we will buy a stock just because the price has fallen.

So what am I doing to help mitigate the risks from this volatility?  Well, as you may recall from last quarter’s letter, I mentioned that I have started using the 200-day simple moving average as an indicator of when to sell securities we own.  I chose this specific indicator for several reasons.  There are a number of popular moving average ranges that traders will employ, from a 10-day moving average to 50-day up to a 250-day moving average.  The shorter the period used, the smaller the losses you might suffer, as the moving average will identify a change in the trend sooner.  There is a cost to this, however.  Typically, if you use a shorter moving average, you end up trading more frequently.  “We’re in the stock.  No, we’re out.  No, we are back in.  Now we are out again….”  Using a longer period means that we may have to endure a bit more volatility in the short-term but we also trade less frequently.  I want to use a signal that will allow us to be investors, not traders.  In addition, the 200-day moving average is popular with many traders making it a broadly watched signal and one that many others will follow as well.  I am still looking for fundamentally sound companies trading at reasonable prices.  I am also primarily looking for us to be long-term investors in the stocks we buy.  However, if the trend in a particular stock changes, I have no problems with selling.  We can always come back and buy the stock again if things change for the better.

I continued to use this moving average this past quarter to help mitigate risks in several stocks we own. We saw, for example, Standard Motor Products (SMP) stock fall below its 200-day moving average.  We have nice gains in this stock, so we trimmed some shares.  In addition, we sold options against our position in this stock.  We took in about $1.40 per share for each option, which mitigates much of the drop in price.  Currently, it looks as if our options will expire worthless.  If so, we will be able to rewrite new options later this month.  However, if the stock closes above $35, we will happily sell (that is the price where we would be obligated to sell our stock) and, given the premium we took in, collect our $36.40 per share to move to greener pastures.

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