What a wild and wooly quarter we just came through! Just to recap a little bit about what we survived last quarter:

• There was major unrest throughout the Middle East leading to regime changes in Tunisia and Egypt, unrest in Syria and civil uprisings in Bahrain and Libya
• On March 10, an earthquake registering 9.0 on the Richter scale hit Japan, damaging much farmland, followed by a tsunami that wrought major damage to a nuclear power plant northeast of Tokyo
• Oil, which started the year at $91.44 per barrel, ended the quarter at $106.77, up nearly 17%
• The unemployment rate continued to decline ever so slightly from 9% in January to 8.8% by the end of March
• Housing starts fell to the second lowest level since 1941
• The Consumer Price Index (CPI), the chief measure of inflation in the U.S., continued to tick up from an annualized 1.6% in January to 2.1% in February (March has yet to be released).

So, with all of this turmoil, strife, unrest and general malaise, stocks obviously tanked… didn’t they? Actually, no. For the quarter, the broad stock market, as measured by the S&P 500 Index, actually gained 5.4%, and the more popular Dow Jones Industrial Average (DJIA) rose 6.4%. One Wall Street aphorism is that a bull market will climb a wall of worry. Obviously, this held for this quarter. However, this positive quarter did not come easily. In fact, the S&P 500 Index climbed 6.6% to its peak in mid-February before dropping 6.23% over the next month only to claw its way back about 5.5% over the last two weeks of the quarter. While that does sound like a wild and wooly ride, there are two key things to note from these market moves.

The first thing is that volatility can be our friend. We took advantage of the recent volatility to either lighten up on a few securities or to add to some current positions. We trimmed positions in client accounts in several stocks including ConocoPhillips (COP), Innophos Holdings (IPHS) and P.H. Glatfelter (GLT) as the market run-up had caused these positions to carry too much weight. By selling off a portion of the holdings, we locked in gains yet held on to shares so we don’t miss any future price increase.

We added a couple of new positions including Delhaize Le Lion (DEG), a Belgian company that is the parent of grocery chain Food Lion, and furniture rental company Rent-A-Center (RCII). In the aftermath of the Japanese earthquake and tsunami we added two Japanese small company funds to several accounts and added to current holdings of these securities in a couple of other accounts. We fully expect that, as Japan rebuilds from the devastation, small companies will be earlier and bigger beneficiaries than larger companies. This may take some time to come to fruition, but we are patient and willing to wait.

We have said many times – and this bears repeating – while we understand that volatility can be stomach churning to you as you watch the value of your portfolio go up… and down… and back up… and back down… we really do embrace volatility as a useful tool. It often gives us the opportunity to sell stocks that reach unreasonably high levels or purchase stocks that are temporarily marked down on sale or to find some other way to take advantage of the mania of Mr. Market’s temporary insanity. Please know that, while we do pay attention to the market on a daily basis, we don’t get caught up in this irrationality.

The second thing to note from this past quarter is that we may be heading for trouble sooner rather than later. The biggest red flag is the rise in the price of oil. Trying to predict where oil is headed is tricky, partly because there is no way to know just how much risk there is in the Middle East. In other words, what are the chances of an extended civil war in Libya that severely disrupts the flow of oil? How much will this affect the long-term price of oil? After all, Libya only produces 2% of the world’s total oil and Libyan oil only accounts for 0.63% of our total imports. The threat, though, is that this civil war spreads to the rest of the peninsula and disrupts oil from Saudi Arabia and other larger producers.

We are currently in a very fragile recovery. The most visible commodity price we see is oil (well, gasoline), but there are many other commodities whose prices have been steadily climbing. Sugar is 62% higher than it was last year, corn has nearly doubled in price, cotton is 145% higher, coffee has doubled, copper is 25% higher and on it goes. We can see the end effects of this in higher food prices, higher prices at the gas pump, and higher costs for manufactured goods. This inflation threatens to derail our recovery, keeping unemployment high. Welcome to the 1970’s – stagflation is back! Now, where did I store my leisure suit?

For those of you old enough to recall, from 1974 through 1981, we had a period of “stagflation” – high inflation coupled with a stagnant economy. This was not supposed to happen according to all economists. If you have high inflation you shouldn’t have high unemployment as unemployed people cannot pay ever increasing prices. However, someone forgot to tell the American economy that the impossible couldn’t happen. I fear we are in grave danger of going back to this very situation. Growing economies around the world, namely Brazil, India and China, are demanding more and more raw materials which is driving up the prices of basic commodities. This is likely to drive our inflation rate higher, as well as costs for basic inputs into the things we buy, build and use go up. Add to that the relatively jobless recovery, lackluster housing starts due to an oversupply of homes for sale and an economy awash in cash that can only contribute to inflationary pressures, and we have a recipe for stagflation.

As the writer of Ecclesiastes said, ‘there is nothing new under the sun.’ Thankfully, we are students of history, so we have some idea of what did work during this period and what didn’t. That period of stagflation was driven by oil (it started with the oil embargo and oil price hike by OPEC nations). There are some key lessons that can be taken from that period. One is that, to quote Jim Cramer of CNBC’s program Mad Money, there is always a bull market somewhere. Investors in oil company stocks, for example, did really well. Many doubled and tripled in price during this period before inflation was tamed by a very determined Federal Reserve led by Paul Volker. We have already positioned clients for potential inflationary pressures with holdings such as the Market Vectors Agribusiness ETF (MOO) and ConocoPhillips (COP). In addition to commodity related stocks, surprisingly small company stocks (small cap stocks, in investing lingo) did well during this period. For example, from 1974 through 1980, when the broad stock market barely moved 1.7% annually, stocks of the smallest 40% of stocks had double-digit gains during this period. As you are aware, we favor small cap stocks such as Oil-Dri (ODC), Nash Finch (NAFC) and recent addition Lifetime Brands (LCUT), so we are well positioned if this trend repeats.

As we look forward, we can only anticipate more volatility, and we expect the unexpected. We will continue to position portfolios for whatever Mr. Market may toss our way and will try to take full advantage of whatever mispricings he provides us. We continue to seek out solid businesses to invest in rather than randomly buying stocks. As long as we focus on good businesses at great prices we should be fine over the long term.

As always, we want to thank you for entrusting us with a portion of your assets. If you have any questions about your portfolio or any other financial planning issue, please feel free to contact us.

Sincerely,

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