​Another quarter down and yet more volatility and uncertainty.  Markets tend to be forward-looking and anticipatory of things to come.  This largely comes from FOMO – fear of missing out.  No one wants to miss the boat when the market turns higher.  So investors attempt to predict and make bets based on these predictions.
 
During the first quarter, the Fed continued to raise interest rates, raising them twice but only by one-quarter of a point in February and again in March.  This left the Fed funds rate in the range of 4.75% - 5.00% at the end of March.  Despite these interest rate hikes, the yields on Treasury bonds actually fell for the quarter as investors seemed to be anticipating rate cuts from the Federal Reserve and sooner rather than later.  Frankly, I expect one more interest rate hike in early-May by another 0.25% leaving the Fed funds rate at 5% - 5.25%, which is where Fed Chair Jay Powell has indicated he thinks rates should be at a minimum to curb inflation.  Let’s look at what investors are seeing and how this has played out in the markets. 
 
At the start of the year, the inflation rate as measured by the CPI or Consumer Price Index had fallen steadily since peaking at just over 9% in June to 6% in February.  There seemed to be two narratives that gave investors hope.  One was that inflation was falling rapidly and would be under control soon.  This would cause the Fed to start cutting interest rates.  The other narrative was that the Fed, by continuing to raise interest rates, would cause a recession and would need to cut interest rates in response.  In both cases, the idea of falling interest rates plays a key role. 
 
We saw this anticipation of rate cuts being played out across both stock and bond markets.  In the bond market, interest rates on Treasury notes and bonds fell during the quarter, dropping by 7% - 9% during the quarter.  At the start of the year, the interest rate on 2-year Treasury notes, for example, were around 4.41% but ended the quarter at just over 4% even.  The interest rate on 30-year bonds fell from just under 4% in December to 3.69% at the end of March.  We can tell a lot about market psychology from the interest rates we see on bonds with different maturities and how these bond yields (interest rate) change over time.  By the end of the quarter, the bond market was anticipating the Fed would cut interest rates by the end of the year.   
 
This tumble in interest rates was accompanied by a rally in the stock market, especially among “growth” stocks.  The key reason for this is that when interest rates are low, companies that have low debt and higher cash flows see their stock prices become more valuable.  We saw this play out as the S&P 500 Index rallied 7.46% for the quarter while the tech-heavy NASDAQ 100 Index gained a whopping 16.77% for the quarter.  Volatility in the stock market was relatively muted until mid-March when we suddenly encountered a banking crisis.  Actually, that should be banking “crisis”.  There was really only one bank in crisis that did lead to a second bank that failed but the idea that we have systemic problem is ludicrous.  I will come back to this in a bit. 
 
Where do we stand in this current environment?  I have been adamant that I believe what Fed Chair Jay Powell has been saying all along.  We are going to see at least one more rate hike and then likely a pause to give the markets a chance to catch up to their policies.  Barring some major exogenous event, I do not see the Fed cutting interest rates this year.  I believe we won’t see interest rate cuts until at least the end of the first quarter of next year.  I don’t see inflation falling to the 2% target very quickly, especially given the issues in the labor market.  In a nutshell, the Federal Reserve is extremely worried about this current inflationary environment being a repeat of the late-1970’s era inflation.  That was a time when we had wage and price spirals going.  Wages for workers would go up, which caused companies to have to raise prices, which caused a new demand for higher wages which led to higher prices and the circle seemed endless.  What broke that cycle was when the Fed under then chair Paul Volker dramatically raised interest rates (anyone remember 15% CD’s and 18% mortgages?) which ultimately stopped this cycle and brought inflation back down to a more normal 3% - 4% range.  The current Fed is laser-focused on this very scenario.  My fear is that they are misinterpreting the situation.  This labor market is not like the one in the 1970’s for many reasons.  The biggest reason is that that labor market had a larger supply of people to tap into than we do now.  Everyone that entered the work force at that point is either retired or retiring and we just do not have enough people to replace them.  This lack of supply of workers will keep wages high but I believe businesses will be limited in how much they can raise prices when most of their consumers are retired and on fixed incomes. 
 
Since the likelihood is that interest rates are going to stay higher for longer, this means the stock market is likely overvaluing stocks.  I think we will see stock prices fall but I do not see a significant meltdown.  I have been saying for the past year that we are in a broad range on the S&P 500 Index between 3,600 and 4,100 and that still seems to be accurate.  At the end of the quarter, the index stood just over the 4,100 level which lines up with my thesis.  So far.  I don’t get too excited when the market hits that 4,000 – 4,100 level and I don’t panic if we fall to the 3,700 – 3,800 level. 
 
The one fly in the ointment that could change the speed at which inflation comes in is the banking “crisis”.  Let me clarify what happened here.  There was a bank – Silicon Valley Bank – that had been growing tremendously, focusing on tech start-up companies in Silicon Valley in California.  The bank’s assets had essentially tripled in size in the past three years, with most of the deposits being corporations rather than individuals.  Banks will typically invest their excess funds into reasonably safe investments such as government bonds.  This bank, during the pandemic, bought 30-year Treasury bonds which are one of the safest investments around.  At the time these were purchased, interest rates were still near zero so these bonds, paying about 3% interest, seemed reasonable.  Then, in 2022, the Fed started raising interest rates.  A basic principle in finance is that bond prices and interest rates are inversely related.  That is, if interest rates go up, the price you can sell a bond you hold will fall.  Conversely, if interest rates fall, the price you could sell a bond you hold will increase.  With interest rates rising these 30-year Treasury bonds that Silicon Valley Bank held tumbled by as much as 20% in value.  These were the worst investments they could have held in a rising interest rate environment.  At the same time as their portfolio of bonds was falling, many of their depositors were looking to move their money to other banks offering to pay more interest.  This caused a “run” on the bank meaning the bank did not have enough liquidity to pay out all the depositors wanting their money.  This happened over a weekend in early March.  The Sunday night after Silicon Valley Bank was essentially declared insolvent, I happened to turn on my TV and it was on the business network CNBC at the time.  They had a “special report” entitled “BANKING CRISIS IN AMERICA” and I thought “what are they talking about?”.  There was one other bank – Signature Bank in New York – that also got caught up in this “crisis”, but in fairness this bank was very involved with cryptocurrency which provided additional risks.  Much of this “crisis” is in the fervent minds of the media who need headlines.  Because of the failure of Silicon Valley Bank, there are likely to be additional regulations that may limit some lending by these regional banks.  The outcome of these new banking regulations will have a similar effect to additional interest rate hikes which may help curb inflation sooner.  However, I still do not think we are going to see a 2% inflation rate this year and the Fed has been very clear on their goal. 
 
With all of this as background, how are we positioning clients for this current environment?  We made minimal changes this quarter.  We are still focusing on “value” versus “growth” as we continue to believe the market is misreading the signals.  We have made a very slight modification to our screen, adding a filter for very high free cash flow to find great companies worth investing in for the long term.  We remain focused on solid companies that continue to grow sales at a reasonable rate and have strong free cash flows they can use to either reinvest into the company, pay dividends, buy back stock or all the above.  We only made two changes of significance during the quarter.  We eliminated our holdings in the Invesco DB US Dollar Index Bullish fund (ticker: UUP).  This fund took advantage of the U.S. dollar being stronger than other currencies which was a result of the rising interest rates.  With that coming to an end and with other countries now raising their interest rates, this fund had run its course, so we sold our entire position.  
 
The other big change we made this quarter was to make a switch in our core balanced mutual fund.  Previously we had been using the Janus Henderson Balanced fund (ticker: JABAX) which is a very good fund.  However, the only reason we used that one was that our all-time favorite balanced fund, the T. Rowe Price Capital Appreciation fund (ticker: PRWCX) had been closed to new investors.  In late February, Capital Appreciation began a limited re-opening and we jumped at the chance to move everyone over from the Janus Henderson fund to the TROW fund.  This fund – what we refer to as a 50% - 70% allocation fund, meaning it will be at least 50% invested in stocks and up to 70% invested in stocks with the balance in cash and fixed income – is the best performing fund of its kind over the past 3-, 5-, and 10-year periods.  As long as the current manager remains at the helm, this will be our “go to” core fund.    
 
Aside from this core fund, one of our largest investments across client accounts continues to be the Janus Henderson AAA CLO fund (ticker: JAAA).  This fund invests in portfolios of senior secured loans with floating interest rates.  At present, this fund is yielding about 5.6% but this is expected to climb to around 6% next month when the interest on the loans in the portfolio are adjusted.  This started out as a place for us to “park cash” and was one of the few investments that was profitable last year.  This fund continues to do well for us, gaining about 1.39% for the first quarter.  I have mentioned in the past that as interest rates peaked, we wanted to find places to “lock in” higher yields.  However, it does not appear that we can do much better than we can in this fund. 
 
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.
 
Sincerely,
Alan R. Myers, CFA
President / Senior Portfolio Manager
Aerie Capital Management, LLC
(866) 857-4095
www.aeriecapitalmgmt.com
​

​ 
We have finally come to the end of a tough year.  This was a year in which there were few, if any, places to hide from the carnage.  Stocks tumbled as much as 25% before bouncing in the fourth quarter to end down 19.4% for the year.  Normally bonds provide at least a cushion to soften the blow, but the numerous hikes in interest rates by the Federal Reserve meant that, while bond yields (the interest rate you can earn on a bond over its life) rose dramatically, the price of bonds fell dramatically.  This means if you held a bond mutual fund at the start of the year, it likely fell around 12.9% for the year.  And the operative watchword for the year was “inflation”. 
 
The inflation rate peaked at 9.06% in June before starting to slowly retreat.  However, by the end of November, it was still at 7.11% - well above the 2% - 3% range the Federal Reserve is targeting.  This has led the Fed to hike interest rates from a range of 0% - 0.25% at the start of the year to 4.25% - 4.50% by December.  We are likely to see a couple of additional rate hikes in 2023 with the expectation being a Fed funds rate of around 5% before interest rate hikes pause. 
 
Inflation is expected to continue to trend down over the next year, but we are not likely to be back at the Fed’s stated goal of 2 – 3% soon.  This will mean that interest rates will be “higher for longer”.  In other words, welcome to the 2000’s.  Interest rates on Treasury bonds are essentially back to the levels prior to the Great Recession.  The International Monetary Fund (IMF) has estimated that global inflation will decline to around 6.5% for 2023 and to 4.1% by 2024.  This argues that interest rates are going to stay elevated through all of 2023 and well into 2024 before there is any chance for relief.  I fully expect the Fed to hike interest rates at their next meeting at the end of January with possibly the last raise coming in March.  If that happens, you will see us start to gradually shift our current bond fund mix from funds that are focused on very short-term, interest rate sensitive bond funds to ones that can “lock in” those higher interest rates for the long term. 
 
In addition to higher interest rates, which are typically a drag on stock returns, we are beginning to see companies laying off workers.  The majority of these layoffs are in the companies that were beneficiaries of the pandemic and the “work from home” trends of the past two years such as DoorDash, Amazon and Peloton.  While some of the numbers sound scary, we need to keep things in perspective.  News media will try to spin things to sound sensational.  Amazon is laying off 18,000 workers.  This is only about 1.1% of their total workforce, though.  DoorDash is laying off 6% of their workforce which totals about 500 people.  Facebook parent Meta is laying off 13% of their workforce or about 9,300 people which is about half of the number they hired during 2021. 
 
These layoffs are certainly something to take note of when it comes to business and the economy.  Many companies overstaffed in the face of boom times during and just after the pandemic.  As I write this letter, the December jobs report has just been released showing continued strength in our economy.  The unemployment rate ticked down slightly to around 3.5% while wages ticked up 0.3% for December.  Wage inflation is a problem that can throw a monkey wrench in what the Fed is trying to accomplish.  In addition, there are still about 10.5 million job openings in the U.S. currently. 
 
Many of the people being laid off from these companies will be able to find other work, though it may not necessarily be at the same pay scale or in the same field.  And there will be some skill mismatch – engineers not wanting to move to retail sales, for example – but all indications are that the Federal Reserve is going to be able to engineer what economists call a “soft landing”.  What the Fed wants is for the economy to slow down to rein in inflation.  This is usually caused by a recession.  In a “soft landing” situation, the economy manages to avoid a deep or long recession.  I would submit that, given the labor shortage we currently are experiencing, any recession we have will not be your father’s recession.  Unemployment is not likely to rise much above the 4% range – well below the 6% - 8% range for most of the past recessions. 
 
So what worked this past year and what did not work?  The one thing that did work was oil and gas.  Between inflation, a relative return to a normal world and the Russian invasion of Ukraine, oil spiked from around $75 per barrel at the start of the year to as much as $120 per barrel by June before returning at year-end to about where it started.  Oil stocks were all the rage.  In fact, if you look at the best performing stocks in the S&P 500 Index for the year, oil stocks were nine of the top ten and 14 of the top 17 performing stocks before you start to get to a more diversified list of companies.  Very little else worked as the only other sector to have a positive return for the year were the utility companies and only by DA1.65% for the year.
 
The three sectors that were off the most were communication services (Google parent company Alphabet, Facebook parent company Meta, Disney and Netflix, for example) which was down almost 41% for the year, consumer cyclical stocks such as Amazon, car dealers and travel and leisure companies with this sector off about 35% and technology stocks which tumbled 31.55% for the year.  All of these sectors and most of these stocks fell into what advisors often call “growth” stocks.  Growth stocks benefit when interest rates are low.  The fact that these sectors fell as much as they did should not be a surprise in light of the interest rate situation. We managed to avoid individual stocks in these sectors during the year.  The only exposure we had was through some of the mutual funds we held.  We did cut most of our holdings in these funds throughout the year, but our one regret was not eliminating them all earlier in the year. 
 
More important than what did or didn’t work this past year is what will or won’t work for the next year or two.  Much depends upon how the economy shapes up, of course, but we have some clues based on history.  As Mark Twain once said, “history doesn’t repeat but it often rhymes.”  We have been going back through history to find time periods that were similar, though, in many ways, this time really is different.  Structurally, the U.S. is in a different place now than it ever has been in history.  That aside, there will be parts of the economy that “rhyme” with the past giving us clues as to what may and may not work. 
 
As for client accounts, we avoided a lot of trading in the fourth quarter.  The biggest moves we made involved the reallocation of fixed income holdings.  We have finally settled on four different funds to use for exposure to fixed income (bonds).  With rising interest rates during the year, this has been a tough sector to find what works.  The four funds we are using include two that take advantage of rising rates by investing in bonds or loans that have adjustable interest rates.  As interest rates increase, the income from these bonds or loans increases, leading to higher income to us as shareholders and a bit more stable price. 
 
The two funds that benefit from rising interest rates are the Janus Henderson AAA CLO fund (ticker: JAAA) and the Wisdom Tree Floating Rate Treasury fund (ticker: USFR).  Both funds ended up for the year with JAAA gaining 0.53% and USFR up 1.98% for the year.  In addition to these two funds, we added two new funds to the mix.  One is a nontraditional, “go anywhere” bond fund from T. Rowe Price.  It is the Global Dynamic Bond fund (ticker: RPIEX) and this fund was up 3.6% for the year.  The last fund we are using in our fixed income mix is not exactly what most investors would think of when it comes to “fixed income”. 
 
When it comes to investing in fixed income securities, the idea is to earn a reasonable rate of interest that compensates for the risk over the time period you are holding the investment.  If you buy a three-year CD, for example, you will want to earn a higher rate of interest per year than if you bought a one-year CD.  The same should hold if you bought a bond that matures in five years.  You would likely ask for a higher interest rate than for the 3-year CD or bond.
 
The fund we are using is the First Trust Vivaldi Merger Arbitrage fund (ticker: MARB).  This fund invests in merger deals.  These are deals where one company makes an offer to buy another company.  When this happens, the price of the stock of the company being acquired will usually jump but there will still be a difference between the current stock price and the ultimate purchase price.  As you get closer to the time when the deal will close, this gap narrows.  Buying shares of the company to be acquired is a lower risk way to hopefully earn a fixed return.  This return is usually related to prevailing interest rates rather than stock market performance.  These types of investments have a low correlation to how the stock market performs and generally much less risk during down markets.  In fact, this particular fund was up 3.89% for the year. 
 
The only other significant trade we made was eliminating our holding in Ingles Markets (ticker: IMKTA), a regional grocery chain.  We sold out of that near the end of November for about a 57% profit in a little more than the year we held the stock.  It’s not that the company was doing anything wrong, but the price was getting well above what we calculated as its fair value.  If things change, we will consider re-entering the position.
 
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.
 
Sincerely,
Alan R. Myers, CFA
President / Senior Portfolio Manager
Aerie Capital Management, LLC
(866) 857-4095
www.aeriecapitalmgmt.com

​September 2022
 
Let’s cut right to the chase.  Ouch.  Tough month.  Tough quarter.  Tough year.  We keep hearing “lowest since….” in regard to the stock market and “highest since…” regarding interest rates.  Inflation has been the story of the year.  We have begun to see signs that inflation may be moderating.  Until it drops significantly though, we are going to see continued interest rate hikes. Just to remind you of where we are, the official measure of inflation topped out at 9.1% on an annualized basis in June.  We have seen a small tick down in the inflation rate to 8.5% in July and 8.3% in August.   That is still an inflation rate we have not seen since early-1982.  This has been the big disconnect that is driving much of the volatility in the markets. 
 
Many traders are saying – hoping, actually – that this small tick down in the rate of inflation will cause the Federal Reserve to pause interest rate hikes.  Some even go so far as to talk wistfully of the Fed “pivoting” – that is, actually cutting interest rates because they have gone too far.  Every member of the Federal Reserve Board has been clear that cutting interest rates is not even on the table for discussion.  At best, we can expect one or two more interest rate hikes and then a pause to see how all of this filters through the economic system.  In other words, once the Fed funds rate – the interest rate that banks pay to borrow money overnight and that largely determines other interest rates in the system – gets into a range of 4% - 4.5%, we can expect the Fed to perhaps stop raising rates for some brief period.
 
What does all this mean to us as investors?  I am firmly in the camp of “listen to the Fed”.  Fed Chairman Jerome Powell has been clear that inflation is their key problem, and they will not back off until the inflation rate is back down to something close to 2% on an annual basis.  My personal belief is that they might be okay with an inflation rate between 2% and 3% per year, but that is still a long way off from the current 8.3% annual rate.  This means we can expect interest rates to continue to rise.  The current Fed funds rate is currently around 3.25% per year.  I think we will see this at a 4.5% annual rate by the end of December.  Higher interest rates are generally not great for stocks for several reasons. 
 
The simplest reason higher interest rates are bad for stocks in general is that investors have an easier choice.  When it comes to investing, the goal is to earn a return on your investment.  When interest rates were essentially zero, there was no alternative.  Investors we forced to buy stocks either for their growth or their dividends or both.  When investors can earn a reasonable interest rate on a bond investment, they now have choices.  Do they buy a bond that pays a guaranteed interest rate of 4% or 4.5% or 5% or do they buy a stock that pays a dividend of 2% and may grow in value over the next year?  With choices like that many investors, especially more risk averse investors, will sell stocks and buy bonds.  This leads to stock prices falling. 
 
Another key reason for higher interest rates being bad for stocks is what we call the “discounted future value” of stocks.  Pardon me if I get a little math geeky for the next paragraph or two.  A share of stock represents ownership of a business and a claim on any current and future earnings of that business.  We invest in businesses that we anticipate will grow over time providing more cash to investors.  However, one dollar earned next year is not worth the same as one dollar today.  Why?  We can take the one dollar we have today and deposit it in a bank and earn interest on that dollar.  The more interest we can earn, the less one dollar one year from now is worth to us today.  For example, if we can earn 5% interest annually today, we could invest $100 today and end up with $105 in one year.  Conversely, if we wanted $100 one year from now, we would only need to invest about $95.24 today earning 5% interest to end up with $100 in one year. 
 
This is a concept called ‘discounted cash flow’ and is the basis for how many investors value a stock today.  These investors will estimate how much cash the company will generate per share into the future.  They will then discount those cash flows back to today to arrive at what is known as the ‘present value’ of these future anticipated cash flows.  This is where interest rates come into the picture.  The higher interest rates are on safer investments like Treasury bonds, the higher the interest rate an investor will demand on a stock to make the risk worth investing.  If I can earn 4% per year buying a Treasury bond which is backed by the U.S. government, I may decide that I need a 10% return to take more risk and buy a stock that may or may not continue to grow into the future.  Going back to the $100 above, if I determine a company is going to return $100 in the future and I discount that at 4%, I am willing to pay $96.15 today for that stock.  However, if I require an 10% return to entice me into buying a stock, I would only be willing to pay $90.91 for that stock today to have $100 in one year.  Apply this same concept across all stocks.  When interest rates were zero, stocks were worth just about anything you were willing to pay.  As interest rates increase, the “discounted” value falls. 
 
Given this set-up, stocks are likely to fall a bit further.  However, I am not expecting a dramatic tumble.  I truly think the worst is behind us.  In part, I believe some of the expectations for higher interest rates are already reflected in current stock prices.  What is not reflected is that investors really have no idea how far interest rates will increase.  I have been saying now for a while that the stock market is seemingly stuck in a range between 3,600 and 4,200 as levels of the S&P 500 Index.  The index closed just below this at the end of September.  I believe investors are expecting the Fed to cut interest rates by another 0.75% in November.  The big question is will they also cut in December and by how much.  This is what could portend some additional volatility and lower prices by the end of the year.  I think this would be short-lived, though as the likelihood is that the Fed will then pause interest rate hikes to see what effect all their work has had on reducing inflation.  That is part of the problem with these hikes.  They take a while to filter through the economic system and affect the inflation rate. 
 
How are we dealing with this volatility given our expectations?  We have already taken several steps and anticipate several more along the way.  In part, we are using the volatility and lower stock prices as a good buying opportunity.  We have added to a few current positions in addition to adding a few new positions and eliminating others.  We added to our holdings in two mutual funds.  One is the Applied Finance Explorer fund (ticker: AFDVX) which invests in smaller company stocks.  We also added a little bit to our Janus Henderson Contrarian fund holdings (ticker: JSVAX) which invests in mid-sized companies.  As the markets fell, we added a little bit to our holdings in Berkshire Hathaway class B shares (ticker: BRK.B) when the stock fell below $300 per share.  This stock may be classified as a “financial service” company based on its insurance businesses, but it almost qualifies as what used to be known as a conglomerate that touches everything from boots to ice cream to bricks and railroads.  In addition to the myriad private companies Berkshire owns, there is also an extensive stock portfolio as well making this holding a hybrid between an insurance company, a conglomerate or holding company and a mutual fund. 
 
We added several new positions this last quarter, several of which should take advantage of higher inflation and interest rates.  We added two stocks of companies that are primarily fertilizer companies.  We bought CF Industries (ticker: CF) and CVR Partners LP (ticker: UAN) to take advantage of elevated food prices and production.  We also added two new positions to take advantage of rising oil prices.  We shifted away from the oil ETF we had traded earlier in the year to a couple of individual oil company stocks.  The first we added was PDC Energy (ticker: PDCE) which is an oil and gas exploration and production firm.  We were starting to evaluate more oil companies as potential investment opportunities when we chose to simplify things and bought the SPDR Oil & Gas Exploration and Production ETF (ticker: XOP).  This is a mutual fund that invests relatively equally across all the stocks we were looking at for this space which simplified this investment for us.   While we readily acknowledge climate change is a real issue, it has become clear that we are not ready to flip a switch and turn off fossil fuels and turn on alternative energy.  We need time to get there and, in the interim, oil and natural gas will continue to be viable and profitable.  We also added another shipping company, Star Bulk Carriers (ticker: SBLK) to our holdings.  This company should continue to profit from the continuing supply chain disruptions though revenues may fall a bit should we have a global recession. 
 
We also added two investments that will take advantage of rising interest rates.  One is the Wisdom Tree Floating Rate Treasury ETF (ticker: USFR) which is a mutual fund that buys Treasury bonds with interest rates that adjust up or down based on the prevailing interest rates in the economy.  This is another safe place for us to park excess cash and still earn a little bit of a return on our money.  This fund has an annual dividend yield around 2.5% with dividends paid out monthly.  We also added shares of the Invesco DB U.S. Dollar Bullish fund (ticker: UUP) which is a mutual fund that trades foreign currencies.  When interest rates rise in the U.S., foreign investors will typically want to buy our government bonds which pay a higher interest rate then their own bonds.  In order to buy our bonds, foreigners need to sell their currencies and buy U.S. dollars.  This drives up the value of the U.S. dollar which is what this fund exploits. 
 
We eliminated a few positions over the quarter for various reasons.  We sold out of consulting company CRA International (ticker: CRAI) with just over a 10% return.  We eliminated Activision Blizzard (ticker: ATVI), which has an offer to be bought by Microsoft.  The merger seems to be running into some regulatory issues, and we chose to step back, taking a small 4% loss.  Should the regulatory picture become clearer, we may return to this stock.  We also sold out of two companies closely tied to the homebuilding industry.  We sold our shares of timber real estate company PotlatchDeltic Corp (ticker: PCH) as the price of lumber continues to fall.  We also closed out homebuilder Tri Point Group (ticker: TPH) as rising interest rates make this holding more of a “value trap” than a value currently.  The Tri Point Group still has value but rising interest rates will likely hamper growth for the next year or two.  We figured we could always revisit this stock when we think interest rates are going to start coming back down.
 
We are continuing to review new investment opportunities and have several new funds and individual investments that we are vetting for risk and potential returns.  These challenging times mean we have to seek out creative solutions.  Some of these solutions we have already implemented, such as the Wisdom Tree Floating Rate Treasury ETF.  This investment is a good short-term solution to rising interest rates but once interest rates peak, we will probably shift much of that investment to bond funds that offer a higher yield.  Rest assured we are doing our due diligence before committing client money to any new investment idea. 
 
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.
 
Sincerely,
Alan R. Myers, CFA
President / Senior Portfolio Manager
Aerie Capital Management, LLC
(866) 857-4095
www.aeriecapitalmgmt.com

​July 2022
 
It would seem that everything old is new again.  We are back to inflation rates that we have not seen since 1982 which caused the Federal Reserve to hike interest rates in June by 0.75% which was the largest rate increase since 1994.  This has led to the worst first six months start to the stock market since 1970.  In addition to high inflation, there are signs that we may technically be in a recession currently.  Economists define a recession as at least two consecutive quarters of negative growth in an economy.  For the first quarter of this year, our GDP or gross domestic production, which is the measure of the growth of the U.S. economy, fell at a 1.6% annualized rate.  Early estimates for the second quarter, which will be released around the end of July, indicate the economy may have contracted at an annualized rate of 2.1%.  If that is the case, then we are technically in a recession. 
 
If we are in a recession, this could help the Federal Reserve out with taming the current high inflation rate.  There is an old maxim on Wall Street that the best cure for high prices are high prices.  This makes some sense as people will tend to cut back on spending when prices jump which eventually causes prices to come back down.  The expectation though, is that the Federal Reserve will continue to be aggressive in raising interest rates as their means to combat an inflation rate that is currently running around 8.6% annually.  However, if inflation drops off rapidly, which it could do from the combination of higher interest rates and a recession, the Federal Reserve won’t need to raise interest rates as much as had been expected.  In fact, the expectations for how far the Federal Reserve will raise their benchmark Fed funds rate has fallen from around 3.8% in early June to about 3.2% currently.  There are some that even expect rate cuts in 2023, should the recession continue, and inflation be reined in.
 
In looking at past recessions and how the Federal Reserve responded, the only period that correlates to our current environment is the mid-1970’s.  The U.S. economy went into a recession in the first quarter of 1974 that lasted for about a year through the first quarter of 1975.  During that period, the Fed funds rate started at around 9.75%, rose to just over 13.3% before being cut back to around 5.5% by the end of the recession.  This was also the era of the oil embargo by the OPEC nations which started in October 1973 and ended in March 1974 but saw the price of a barrel of oil rise four-fold from $2.90 per barrel to $11.65 per barrel.  It was this oil shock coupled with easy money and a lack of fiscal discipline, especially around spending to fund the Vietnam War that pushed the U.S. economy over the edge into a recession.  While $11.65 per barrel oil seems quaint now, that would be the equivalent of oil at over $200 per barrel today.  Mark Twain once said that history does not repeat itself, but it does often rhyme.  This would be one of those cases. 
 
The current environment we find ourselves in has echoes of the 1970’s oil supply shock in the pandemic-induced shortage of just about everything.  Add to that the easy money of zero interest rates and the three stimulus checks given out to spur the economy during and post-pandemic and we have a similar situation to the mid-1970’s.  Much of the reason for the current oil supply issues revolve around oil companies dramatically cutting back on what is known as “capital spending” – the money they would spend to explore for and drill new wells or to bring old wells back on-line.  The key reason oil companies are reluctant to spend that money is a long history of “boom-bust” cycles in the oil patch.  It would seem the companies have finally learned their lesson not to ramp up spending just because oil prices have jumped.  In addition, even if more wells were brought back on-line, there is an issue with a lack of refineries to turn the oil into gasoline.  Currently, the refineries we have in the U.S. are operating at about 94% capacity.  The capacity that is not being utilized is due to maintenance and repairs being done to the facilities.  In fact, no new refinery has been built in the U.S. since 1977.  There have been upgrades to some older refineries over the years, but we still lack a capacity to refine much more oil into gasoline.  And no oil company is going to commit to a years-long project and spend over $1 billion to build another refinery of any size with the pressures of investors bearing down on them to reduce their carbon footprint and shift to renewable energy. 
 
All of this has led to a very tough investing environment.  The broad stock market fell over 8% in June alone taking the market down just over 20% for the year-to-date period and putting us in what is generally regarded as a bear market.  Making things more challenging is the fact that many investments that should have done well this year have not performed as expected.  You would think that mutual funds that invest in bonds that take advantage of rising interest rates would be knocking the cover off the ball right now.  Most are down between 1.25% and 1.5% for the year despite three interest rate hikes so far this year.  Even the mutual fund that invests in TIPS – Treasury Inflation Protected Securities or bonds that automatically adjust their value to protect holders from high inflation – lost over 9% of its value for the year!  This has affected our current lone bond holding, the Janus Henderson AAA CLO ETF.  This mutual fund, which invests in the safest short-term loans, has seen its dividend yield increase from around 1% at the start of the year to 2% currently.  However, the share price has fallen a little over 2% since the start of the year, which has dragged down performance. 
 
One of the few areas that has done well has been oil and oil stocks.  While we don’t own any oil stocks (yet), we did make some money by trading in this space.  We sold an option that obligated us to buy shares of Continental Development for $6 per share which we closed early, earning a 4.54% return in a month.  We also obligated clients to buy shares of Occidental Petroleum at $50 per share just before news broke that Berkshire Hathaway had taken a large 7% interest in the company and the share price jumped to over $60 per share.  We still earned a 3.2% return in a month on our investment.  We also made some trades in the United States Oil Fund LP ETF, a fund that is tied to the price of oil using futures.  Over the five-month period that we traded options in this fund, we earned between a 36% and 47% return without risking more than 1% of a client’s account. 
 
We do currently have options outstanding obligating us to buy shares of PDC Energy Inc. (ticker: PDCE), formerly Petroleum Development Corporation.  We are currently obligated to buy shares at $59.50 but given the premium we have collected our cost would be about $57.80 per share.  In addition, we have earned a 3.32% return from selling a previous option that expired worthless.  As much as we as a country need to make a shift to clean, renewable energy, we are not ready to make that leap just yet and oil and some oil companies will continue to do well for the next few years. 
 
We did add two new funds to client accounts this quarter.  We have tiptoed into the Applied Finance Explorer fund (ticker: AFDVX).  We have been familiar with Applied Finance group since shortly after we started our firm.  The Applied Finance Group began as a company selling research on companies to portfolio managers.  They eventually branched out into managing money and then started mutual funds.  The Applied Finance group has what I think is a unique approach to calculating the value of a stock.  They do not use traditional “value” or “growth” metrics that most mutual fund managers box themselves into using.  Instead, they look at what they call the “economic value added”.  That is, does the company they are evaluating create or destroy shareholder value.  They are looking for companies creating shareholder value.  This sort of approach is one that appeals to me and is similar to my methodology.  This fund invests in small companies.  We only have a small position currently but expect us to add more shares on weakness in the markets. 
 
We sold out of the BlackRock Mid Cap Growth fund this past quarter. While we did well in that fund, notching a 40% gain while we held it, this fund was becoming too risky in the current environment.  We began to move to the Janus Henderson Contrarian fund (ticker: JSVAX) for exposure to midsized company stocks.  This fund marches to the beat of its own drummer.  What I mean by that is the fund is happy to find value wherever it can rather than following a particular benchmark.  This has proven to be successful, leading to smaller losses during tough times and better returns during good times.  Again, we have just a small position so far, but expect us to continue to add to this on market pullbacks.
 
We did eliminate three holdings from last year, selling out of Hillenbrand Inc. (ticker: HI) with a 13% loss on this stock.  The company has been showing more weakness lately which prompted the sale.  We also closed out our Hologic Inc. (ticker: HOLX) position for a small 2.32% gain.  Our biggest success came with Sanderson Farms, Inc. (ticker: SAFM), one of the largest producers of chicken.  A partnership of Cargill and Continental Grain agreed to purchase Sanderson Farms for $203 per share in cash.  We originally purchased shares for around $189.70 per share at the end of December.  We expected to lock in a 7% return once the deal closed later this year.  However, in late-June, shares of Sanderson Farms were trading above the $203 merger price, so we sold our shares for just over $210 per share, notching an almost 12% return in six months.  Likely, the market is expecting the merger deal to be modified with additional funds from private equity to get around some governmental concerns regarding too much concentration but in the absence of a definitive deal, we will take the sure thing now. 
 
In addition to the PDC Energy stock mentioned above, we have sold options against several other stocks that we want to buy.  Why are we selling options rather than just buying the stocks outright?  The key reason is that we are taking advantage of the increased level of volatility in the market.  This increased volatility which arises from the uncertainty about what the market will do allows us to earn large premiums from selling an option that obligates us to buy the stock at a set price.  If the stock falls, we end up buying the stock but at a more favorable price.  If the stock doesn’t fall, we still make money from waiting – usually 2% - 3% on the amount we are setting aside for the purchase within a 30-day period. 
 
In our last quarterly letter, we suggested that, if you had excess cash that you could “lock up” for at least one year, you should look into buying a Series I Treasury bond.  This can be done by going to http://treasurydirect.gov and setting up an account to have money drafted from your checking or savings account to make the purchase.  You are limited to $10,000 in purchases per person per year for these bonds.  When we made this suggestion back in February, the I-bonds were paying a little over 7% interest on an annualized basis.  These bonds have their interest rate adjusted twice per year and a portion of the interest rate is based on the current inflation rate.  If you have not taken advantage of these bonds yet, now is a good time to consider them.  The current interest rate on these bonds will be about 9.62% per year.  For those of you that did take advantage of them earlier, you will get this same rate, so you are not missing out on anything.  Again, let me reiterate that you cannot redeem these bonds within the first year of purchase.  After one year and before five years, you can redeem them, but you will lose the previous three months’ worth of interest.  After five years, you can redeem them for their then current value, and they fully mature in thirty years.  We will continue to update you on these bonds.
 
We are currently holding more cash in client accounts than we normally would but much of that cash backs up many of the options we have sold. For example, we sold options that obligate us to buy shares of agricultural chemical company American Vanguard Corp. (ticker: AVD) at $20 per share.  For every 100 shares that we want to purchase (each option represents 100 shares), $2,000 is set aside to make sure we can buy the shares should the stock price drop to $20 or less.  In the interim, we have earned a premium of $31.25 for taking on this obligation.  That may not sound like a lot but that equates to 1.56% in just 24 days.  While I hope to purchase the shares, should we not have to when the option expires in mid-July, we will simply try this same strategy again.  You can expect that we will gradually add more equity names – both individual stocks and additions to mutual fund holdings on weakness in the markets as we do not expect this downturn to be a long-term event.  Unless we are exceedingly lucky, we won’t buy at the exact bottom, but we will generally buy at favorable prices.  You can also expect us to gradually add more exposure to bonds to client accounts, especially as interest rates finally offer a more attractive return than zero percent.
 
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.
 
Sincerely,
Alan R. Myers, CFA
President / Senior Portfolio Manager
Aerie Capital Management, LLC
(866) 857-4095
www.aeriecapitalmgmt.com

If you go back to my last client quarterly letter, you will note that I managed to nail what we have seen so far this year.  Increased volatility in the stock market?  Check.  A ten percent correction?  Check.  Higher interest rates?  Check.  Lower stock prices?  Check.  While I did not mention war, anyone who did not seriously think Russia was going to invade Ukraine was fooling themselves.  In early-February, I wrote a note that was posted on our website which addressed some of these issues.  In that blog post (https://www.aeriecapitalmgmt.com/blog), I tried to explain why we had more volatility this year.  Let me address this briefly here.  The answer started with explaining how rising interest rates affected the value of stocks. 
 
How do rising interest rates affect investors?  Let’s start with the fact that stocks represent ownership in a business.  These businesses earn a profit.  Let us look at a very simple problem.  Suppose we own a business that earns $1,000 per year.  We anticipate it will earn this same amount every year until the end of time.  Suppose further someone wants to buy our business from us.  What would we be willing to accept to sell this business?  If we expect to earn the same thing every year and if interest rates are 1% and we do not expect that to change, it turns out we would be indifferent between earning $1,000 each year or receiving $100,000 up front.  These two amounts would provide the same outcome.  In finance lingo, this $100,000 is the “present value of all future cash flows”. 
 
What happens if interest rates go up?  Suppose we can now earn 2% interest on any money we invest today.  As you might suspect, doubling the interest rate cuts in half the amount of money we would need to accept today to earn the same set of cash flows.  In other words, we would be equally happy with $50,000 in hand today or $1,000 per year forever.  Rising interest rates reduce the “present value” of future cash flows.  The value of our business has fallen in half.  The price a stock trades at represents what investors think the present value of future cash flows are worth.  The cash flows, of course, are the future earnings of the companies.  This raises two key questions.  The first is when the Fed is all said and done raising interest rates, what will be the prevailing interest rate?  3%?  5%?  6%?  No one knows.  The second question is what will companies earn?  If Apple earned $6.00 per share last year, is that sustainable?  Might it continue to grow?  Could it shrink if we have a recession?  These two questions – the level of interest rates and the future earnings of companies – are leading to the current levels of volatility.  In other words, if you think Apple will earn $7 next year and interest rates will settle around 3.5%, then you are willing to pay up to $200 per share to purchase Apple stock.  Meanwhile, I may think Apple has stalled out and earnings will not grow but will remain at that $6 per share level.  Further, I think interest rates will climb to 4% when all is done, so I am only willing to pay $150 for a share of Apple.  The disparity between investors beliefs is what leads to volatility.
 
Besides the increased volatility, the other two key issues – both linked to each other – are inflation and oil prices and gasoline prices.  Oil is a key component of the basket of goods that determine the inflation rate so when that spikes, inflation spikes, too.  So when can we expect some relief from this inflation and how will that happen?  Pardon me while I get just a little bit wonky and discuss economics for a bit. 
 
Let me explain just exactly what inflation is and how it is measured.  Inflation is when prices are rising in an economy.  This is measured by what we call the consumer price index or CPI for short.  This index is based on a market basket of goods and services that most Americans use on a regular basis.  Key items, of course, are food, gasoline, housing costs and normal consumer purchases.  The value of each item is measured and compared over time and the change in the value of this basket of goods and services reflects the inflation rate.  Currently, energy costs comprise almost 25% of the value of the index, so a change in the price of oil would have a large impact on the CPI and thus inflation.   Through February, the CPI rose 7.9% on a year-over-year basis.  Energy (fuel oil and gasoline) was up 25.6% and was obviously a major component of the current inflation rate.   
 
Up until the end of last year, I was of the opinion the inflation rate we were seeing last year was “transitory”.  That is, I thought it was an anomaly that would quickly pass as we returned our economy to a more normal state.  Sadly, this is not the case and energy costs are a big reason for this and a major source of controversy.  There are several reasons for the spike in price for oil and gasoline.  Most have little to do with the memes you see on Facebook or hear about from some politicians.  They all want to blame President Biden for canceling the Keystone XL pipeline or for not allowing oil drilling on Federal lands.  Neither of these have anything to do with the current spike in oil prices.  The Keystone pipeline, which brings oil from the tar sands region of Canada down to the Gulf Coast, has been operational since 2010.  The Keystone XL pipeline was to be a shorter route that connected the starting point in Canada to the existing pipeline in Nebraska.  TC Energy, the company that operates the pipeline, touted that the XL pipeline would carry “up to 800,000 barrels of oil per day” but failed to mention that most of that oil would come from the Bakken region in Montana and North Dakota as it ran through that area – oil that is already being shipped anyway.  In other words, the pipeline would not have added 800,000 barrels of additional oil to the U.S. economy contrary to what politicians and memes claim.  There might have been some incremental increase but certainly not to that level. 
 
Congress recently took the oil companies to task for making billions in profits and using this money to buy back their own stock rather than reinvesting in more oil wells.  There is some legitimacy to this claim, but it is a gross over exaggeration.  Yes, oil companies did earn a tremendous profit in the past year.  However, over the past two decades they have had a boom-bust cycle.  When oil prices would climb, oil companies would rush to drill new wells to capitalize on the high oil prices.  This led to more oil on the market and lower oil prices and losses forcing cuts in production which eventually led to less oil production and eventually higher oil prices.  Oil companies may have learned from their past mistakes and are slower to bring new oil wells on-line.  Add to this the loss of over 12,000 jobs in the oil patch from the pre-pandemic high and that adds to the difficulty in restarting old wells or drilling new ones.  The money the oil companies are spending to buy back their own stock is being done because they really have no other place to spend the money that brings added value to shareholders. 
 
Another issue impacting oil production is a shift in sentiment among primarily institutional investors (think mutual funds, large college endowment funds and large pension plans) that encourage a shift to greener energy and less focus on industries that cause greenhouse gas emissions to rise.  This can make it hard for oil companies to raise additional capital for drilling more oil wells.  That may be counterintuitive in light of the fact I just said oil companies earned record profits.  Oil companies will try to spread the risk of drilling new wells by attracting outside investors who share both the expense and some of the profits for drilling these new wells.  Oil companies could do this all themselves but prefer to spread the risk around. 
 
Lastly, we have the war in the Ukraine also impacting the price of oil.  Due to Russia’s invasion of Ukraine, stiff sanctions have been imposed on Russia including on Russian oil.  Russia is the sixth largest producer of oil in the world and currently no one is buying their oil to punish them for invading another sovereign nation.  This has taken about 11 million barrels of oil per day off the market, driving up the price of the oil that is still out there.  Should the war end soon with Russia’s complete withdrawal, the sanctions would likely end, and Russian oil would flood the market driving down the price of oil in the short run.  However, oil would likely settle in the $80 - $85 range (oil is currently around $96 per barrel as I write this) which is where it was before the Russian-Ukraine situation. 
 
With all of this being said, what are we doing about this either to protect clients or to take advantage of the situation?  We made several moves that were designed to protect us from some potential losses.  For example, in early January with inflation being universally acknowledged as an issue, retail stocks were starting to suffer losses.  This makes sense.  Costs for the goods they sell go up.  The stores may not be able to pass along all the cost increases.  That would be a drag on their earnings.  We purchased options that would benefit from a drop in the price of a group of retail stocks.  This proved successful as we generally netted a 25% gain in client accounts in the span of about three weeks.  We also sold options on two separate occasions that obligated us to buy an ETF (exchange-traded fund) tied to U.S. oil as a bet that oil prices were going to continue to move higher.  This is, of course, what happened, allowing us to net 9% the first time and 9.2% the second time we made these trades. 
 
As stock prices fell, more companies became values to us, and we added several new positions this quarter.  We bought shares of Activision Blizzard (ticker: ATVI) for around $80 per share.  Currently, Microsoft has offered to buy the company for $95 per share.  There are a few in Congress who are saber rattling against the merger (Elizabeth Warren and Bernie Saunders, for example) but my expectation is this is a lot of noise and hot air and will come to naught.  We also added shares of consulting company CRA International (ticker: CRAI), industrial company Hillenbrand Inc. (ticker: HI), medical diagnostic equipment manufacturer Hologic Inc. (ticker: HOLX), container shipper Matson Inc. (ticker: MATX), interior electrical wiring company Encore Wire (ticker: WIRE), and residential homebuilder Tri Pointe Homes, Inc. (ticker: TPH) to client accounts.  We also bought shares of Ford (ticker: F) as we viewed this stock as a reasonable way to invest in electric vehicles without taking the risk of the many new entrants into that space. 
 
In addition to these new equity investments, we made some major adjustments to client fixed income (bond) investments.  We eliminated the two bond funds we held as they not only were lagging but promised to be more of a drag as interest rates start rising.  We shifted most of our fixed income investment to the Janus Henderson AAA CLO exchange traded fund.  This mutual fund invests in CLOs or collateralized loan obligations – bank loans – but only those with the highest credit rating.  This results in a slightly lower yield relative to other funds that invest in bank loan debt but more safety.  When we started buying shares, the fund sported a dividend yield around 1.13% but we expect that to increase dramatically this month.  The loans the fund holds are floating rate loans, meaning the interest rates paid on the loans adjusts periodically.  These CLOs reset their interest rates quarterly and are set to adjust in April.  In our conversations with the portfolio managers, he expects the dividend yield to increase to around 2% for the fund.  In addition to this fund, we have found a solid “core plus” bond fund that will be our “go to” bond fund.  We have started with a small allocation of around 1% of client accounts to this fund and expect to gradually scale into this fund as interest rates continue to climb, and we can add shares on periodic price drops. 
 
We weren’t just busy adding new investments this quarter.  We also eliminated a few holdings and trimmed several others.  We sold out of our Atlas Air Worldwide stock earning a 30% return in about a year, eliminated retailer Citi Trends with a small gain in some accounts and a small loss in other accounts.  We trimmed several growth-oriented mutual funds including the BlackRock Mid Cap Growth fund, the Putnam Small Cap Growth fund, and the Putnam Growth Opportunities fund.  We eliminated our holding in the Virtus KAR Mid-Cap Growth fund.  That fund had been a stellar performer for us but had become quite the anchor in the first quarter of the year.  In retrospect, we probably should have trimmed or eliminated these funds sooner and faster as the values of these funds fell, dragging down our performance a little more than we would have liked for the quarter. 
 
At quarter-end, we are in a reasonable position with our stock and bond holdings.  We are being a bit more aggressive in hedging client portfolios with options as well as using option strategies to add income to client accounts.  I would expect to see a few more equity positions coming into client accounts as stock prices continue to be volatile providing opportunities to add good companies at great prices.  As a last note, we recommended to many of you a direct investment in Series I Treasury bonds.  These bonds, which can only be purchased through the website http://treasurydirect.gov , are currently paying a little over 7% interest through May.  The interest rate on these bonds is reset semiannually and is based on the inflation rate.  As the inflation rate is expected to remain above 7% for now, we can expect these bonds to continue to pay at this rate through November.  We will keep you informed on what to do with your I Bond holdings.
 
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.
 
Sincerely,
Alan R. Myers, CFA
President / Senior Portfolio Manager
Aerie Capital Management, LLC
(866) 857-4095
www.aeriecapitalmgmt.com

​We turned the page to a new year, and it seems an entirely new market, as well.  Until January, the stock market was buoyed by the knowledge that the Federal Reserve would continue to pump money into the economy.  What this most often meant was shallow pullbacks of around 5% followed by “buying the dip” mentality that quickly drove stock prices back to new highs. Even when we had the pandemic shutdown in 2020, the market recovered most of the 35% drop within two months and all the loss within five months.  This relentless push upward is what investors have been conditioned to expect. 
 
So what changed and what does it all mean?  For one thing, inflation has become a more serious problem.  Inflation first appeared in the second quarter of last year, but everyone (including me) thought it was “transitory”.  That is, everyone seemed to think the spike in inflation was largely due to comparing a year in which we were returning to normal to a year in which the economy was shut down.  The idea was that as we got further into the year, comparisons would moderate, and inflation would come down.  That has not happened.  The inflation rate has remained at a stubbornly high level for the remainder of the year.  This has forced the Federal Reserve to dramatically shift their policy from one of “easy money” – that is, keeping interest rates low and buying bonds from the public to add additional dollars to the economy – to one of tightening.  This tightening is a two-step process.  The first step involves ending the QE or bond buying program, which is already happening and should be over by March.  The second step will be to raise the Fed funds interest rate.
 
It is the rising interest rates that are directly affecting the markets even though the Fed has not acted yet.  How do rising interest rates affect investors?  Let’s start with the fact that stocks represent ownership in a business.  These businesses earn a profit (or we anticipate they will at some point).  Let us look at a very simple problem.  Suppose we own a business that earns $1,000 per year.  We anticipate it will earn this same amount every year until the end of time.  Suppose further someone wants to buy our business from us.  What would we be willing to accept to sell this business?  Flipping this question on its head, if we could earn 1% interest on an investment, how much would we need to invest today to end up with that same $1,000 in a year?  The answer is $990.10 invested today earning 1% gives us the same $1,000 in one year.  We could make this same calculation of how much we need to invest to end up with that same $1,000 for the second year and the third year and so on and add them together to get a figure for the value of the company.  Simply put, we are discounting the cash flow we expect to earn from our business back to present day.  If interest rates are 1% and we expect to earn this amount forever and ever, it turns out we would be indifferent between earning $1,000 each year or receiving $100,000 up front.  These two amounts would provide the same outcome. 
 
What happens if interest rates go up?  Suppose we can now earn 2% interest on any money we invest today.  As you might suspect, doubling the interest rate cuts in half the amount of money we would need to accept today to earn the same set of cash flows.  In other words, we would be equally happy with $50,000 in hand today or $1,000 per year forever.  Rising interest rates reduce the “present value” of future cash flows.  Stock prices represent this “present value” of future cash flows.  The cash flows we are discounting are the earnings of the companies.  This raises two key questions.  The first is when the Fed is all said and done raising interest rates, what will be the prevailing interest rate?  3%?  5%?  6%?  No one knows.  The second question is what will companies earn?  If Apple earned $6.00 per share last year, is that sustainable?  Might it continue to grow?  Could it shrink if we have a recession?  These two questions – the level of interest rates and the future earnings of companies – are leading to the current levels of volatility.
 
Investors are confused by both the continued growth rates of the companies they own and of the prevailing interest rates we are going to see in the economy.  The one thing all investors agree upon is that with interest rates likely to start rising in March, stocks are worth less today than they were in December.  The volatility arises from the debate over what stocks will earn and what interest rate is appropriate.  If interest rates go up too quickly or too far, stocks will tumble dramatically.  If inflation is less severe, interest rates may not rise dramatically, and stocks may have more value.  The trouble is, no one knows exactly what a company will earn next quarter, let alone next year or three years or ten years down the road.  This means we have no idea what number to use to discount back to today.  In addition, no one really knows how far the Fed will raise interest rates.  There have been guesses of anywhere between three interest rate hikes this year and seven(!) hikes.  The answer to this question depends upon how the rate of inflation responds to the first rounds of interest rate hikes as well as how company earnings respond. 
 
We have not been sitting idle during this volatile time.  We have already taken several steps for our clients.  Over the past couple of years, we have been a bit more focused on growth largely utilizing mutual funds.  These funds typically had a high allocation to tech stocks.  Tech stocks will likely be impacted by rising interest rates.  To counter that, we have greatly reduced or eliminated our exposure to these mutual funds and will continue to trim as appropriate.  This does not mean we are giving up on growth altogether – just that we are paring back significantly to focus on areas that are likely to do better.  In addition, we have started dipping our toes in the water or, more appropriately, oil.  Oil has been on the rise lately and is a key component of the inflation calculation.  There is an ETF, the United States Oil Fund L.P (ticker: USO) that is tied to the price of oil.  We have a couple of trades around this security and expect to do more to take advantage of higher inflation. 
 
Another change we have made is to invest excess cash in a bond fund that will benefit from rising interest rates.  We view this largely as a short-term place to park cash and less as an investment or a trade.  The fund, the Janus Henderson AAA CLO ETF (ticker: JAAA) sports a current dividend yield around 1.10% per year and the price is relatively stable.  It is important to note that this is not a money market fund and stable prices are not guaranteed.  The fact that the bonds it owns are high quality gives us some level of assurance for the safety of our investment.  Further, these bonds are backed by corporate loans that have adjustable interest rates.  As interest rates rise over time, so will the payouts on these bonds and our dividend yield should increase comparably.  We are not looking to hit home runs here.  We are trying to enhance our returns a bit without taking undue risk.  All of this is designed to help shelter us during these volatile times.  We may have losses on paper as stocks rise and fall, but if we do our job correctly, we will have smaller losses which gives us the chance for quicker return to profitability.    

Another quarter and year have ended.  If we had to sum up the year in one word, it might be “inflation”.  Inflation seemed to be on everyone’s mind for most of the year.  We debated whether it was “transitory” or not, whether President Biden could reign it in (hint:  Presidents have very little control over the economy, especially in their first year in office), and whether we were headed for that old 1970’s hit, stagflation or not.  As I looked back at quarterly letters I sent this past year, I was pleasantly surprised at how prescient I was about things.  Of course, that is part of my job – to be able to read the tea leaves of the economy so I can better position us for what may come. 
 
I will reiterate what I said last quarter.  This world is often random and chaotic and only makes sense in retrospect.  Proof of this is in the stock market.  On the next-to-last trading day of the year, the market as measured by the S&P 500 index notched its 70th record high close for the year.  On the last trading day of the year, the index was in new record territory until literally the last 14 minutes of the day, when it fell 0.26% for the day.  Did anything of significance happen to cause this?  Likely, it was simply investors trying to lock in gains exacerbated by low trading volume.  In other words, there were not a lot of investors trading which created more risk and wider moves in stock prices.  As investors sold, the lack of buyers allowed prices to fall.
 
While many random events can occur, putting a frame around what could or is likely to happen helps.  The problem is always the unknowns that we don’t know but we can speculate on the things we do know.  We do know the Federal Reserve is tapering their bond buying.  Since the start of the pandemic, the Federal Reserve has been buying bonds from the public.  This has the effect of putting more cash into our financial system (the Fed pays cash for the bonds they buy).  The Federal Reserve owned about $4.2 trillion in bonds just prior to the pandemic shutdown at the end of February 2020 and today has about $8.8 trillion in bonds.  This means the Fed has added $4.6 trillion in cash to our financial system.  This cash had to go somewhere, and much of it likely ended up in the stock market.  In fact, this cash accounts for about a third of the growth in the value of the U.S. stock market over the period from the end of 2019 through the third quarter of 2021. 
 
Does this lack of further cash infusions have any implications for us as investors?  I believe we are likely to see more volatility, larger pullbacks, and longer recovery times from these corrections.  Investor sentiment lately has been to “buy the dip”.  This has proven to be a winning strategy keeping drops in the market relatively shallow essentially since the Great Recession.  Even with the large drawdown during the pandemic last year, the market recovered amazingly quickly.  The only other significant drawdown occurred in November and December 2018 when the Federal Reserve was raising interest rates during a serious trade dispute with China.  This all combined to make investors very nervous.  Since there was no end in sight to the potential problems, investors could not figure out when to buy.  The turning point was when Fed Chair Jay Powell capitulated and reversed course on more rate hikes the following year. 
 
I suspect we are going to see more volatility this year, and at least one pullback of more than 10% in the market.  I want to be clear that I am not advocating for selling and going to cash.  Quite the contrary.  I think any pullback of 10% or more will create some good buying opportunities.  I am more likely to sell into strength, so we have some cash sitting on the sidelines for these potential market fluctuations. 
 
We also know the Federal Reserve is going to raise interest rates.  Jay Powell has told us so and the Fed really needs to keep inflation in check.  The market is anticipating at least three rate hikes over this next year.  The first one is not likely to occur until the Fed ends their quantitative easing (bond buying) which is likely to occur by March.  If the Fed sticks to the script, we will probably see the first interest rate hike by June.  What could turn the markets on its head is if we get a larger than expected hike or if we get more than three hikes this year. 
 
The biggest change we are likely to see is in the types of stocks that lead the market.  As interest rates increase, this will make the high growth stocks that have been the market leaders over the past few years less attractive.  We have already started seeing this changeover in leadership.  When you look at the best performing stocks for 2021, the top of the list is littered with oil companies and basic industries like Devon Energy, Marathon Oil, Old Dominion Freight Line and fertilizer company CF Industries.  We have already started seeing a shift in companies fitting our criteria that align with this shift in focus.  If you recall, in the third quarter of the year we added timberland REIT PotlacthDeltic Corp (ticker: PCH) which we purchased back in August.  This quarter, we added shipping company Matson Inc. (ticker: MATX) in early December.  We also added shares of Hillenbrand Inc. (ticker: HI), an industrial company that is probably more famous for starting life as Bates Casket Company which they still own.  We are starting to see more signs of “value” stocks in our lists and expect this trend to continue over time. 
 
The two biggest questions – and the biggest unknown – is how quickly interest rates will rise and how far.  The latter answer depends upon your view of inflation.  Many have been in the “transitory” camp meaning they think the high inflation rate we are seeing will resolve itself as Covid fades and the supply chain fixes itself.  If this is the case, interest rates will not rise significantly.  Others are not so sanguine on this scenario.  I have been gradually moving from the former camp to the latter though I am not worried about a permanent high inflation rate as are some pundits.  I see some things – higher wages required to entice people back to work and a permanent labor shortage due to a lack of people with the necessary skills – that will drive higher prices for a long time to come.  This pandemic has sped up some trends that were inevitably coming.  I think we will end up with a semi-permanent modestly higher inflation rate than we have been used to over the past decade.  In other words, a return to normal.  I would not be surprised to see interest rates top out around 4 – 5% annually on a 10-year Treasury bond.  The yield on this bond has been the measure everyone is paying attention to currently.  As I write this, the bond is paying about 1.66% annually.
 
The toughest part of navigating the inflation and rising interest rates issue is balancing off stocks versus bonds.  I have been saying for a number of years that we are in a “TINA” world – there is no alternative to investing in stocks.  That will change as interest rates rise.  At some point, bonds will be a viable investment alternative.  In the interim, bond investments are merely a place to park cash and a bit of an anchor for a portfolio.  We recently made a small change in the fixed income allocation in client accounts.  We eliminated the SPDR Bloomberg Investment Grade Floating Rate ETF (ticker: FLRN) in favor of the Janus Henderson AAA CLO ETF (ticker: JAAA).  This fund invests in debt instruments called “collateralized loan obligations”.  These are large, first-lien senior corporate loans.  These loans have adjustable interest rates which means that as prevailing interest rates in the economy rise, so does the interest paid on these loans.  The loans this Janus fund holds tend to be very high quality, yet the fund offers a much better dividend yield than the SPDR fund we held without compromising safety. 
 
After many months of intensive research, I have finally found a “go anywhere” bond fund that I think will provide the safety our clients need and deserve without compromising returns.  You can expect to see the T. Rowe Price Total Return fund showing up in accounts soon.  This fund had the singular distinction of having a positive return last year when most other broadly diversified bond funds did not.  So with the addition of the Janus Henderson fund to help us in a rising interest rate environment and as a place to “park cash” and the soon-to-be-added T. Rowe Price broadly diversified fund, we have the fixed income piece of the puzzle covered for client accounts. 
 
Hopefully, despite my expectations for increased volatility, we can settle down to a more comfortable buy-and-hold strategy versus the amount of trading we did over the past year.  While this trading did play out in our favor for the most part, I am just not a big fan of trading too much.  During the fourth quarter, we eliminated several stocks including Clearwater Paper earning between a 10% and 20% return, Camping World Holdings with a small loss, Quest Diagnostics for a small 5% profit and Williams-Sonoma with gains between 35% and 40% on our investment.  We also cut back on the Virtus KAR Mid-Cap Growth fund due to the level of risk in that fund and its holdings.  Upon further review, we will likely eliminate this fund from the lineup this year.  Thankfully we have one or two other funds already in client accounts that can take up where this fund left off.
 
We did add a few new positions this quarter.  I mentioned earlier adding shares of shipping company Matson and industrial company Hillenbrand.  We also added shares of chicken producer Sanderson Farms Inc. (ticker: SAFM) which is in the process of being acquired.  There is some risk from the new Biden administration that the acquisition will not go through which gave us the opportunity to acquire the shares at a discount.  Should the merger be completed, we will earn a 7% return in a reasonably short period of time.  If the merger is not consummated, Sanderson Farms still represents a great bargain at the price we paid so this is a win-win either way. 
 
Finally, towards the end November, we dipped our toes into the EV, or electronic vehicle, space by obligating clients to purchase shares of Ford for $17 per share.  We wrote (sold) a put option and collected a premium for this obligation that is paying us a 2.76% return over the 52 days the obligation is outstanding.  Likely, this option will expire worthless, and we will simply write (sell) another put option to again collect more premium.  Part of the reason for doing this is that I really think the price we are seeking to pay is a fair price.  Ford currently makes one of the most popular vehicles of all time, the Ford F-150 pickup truck.  They have now introduced an EV version of this truck that has proven so popular, they are having to double production in the first year of manufacture.  This type of news has caused the stock to pop to a value that is, in my opinion, excessive and I refuse to chase this stock or pay too much just to gain access to what is a “hot” sector of the market currently.  I would rather be patient and continue to collect premiums and let the stock come back to us.  As I mentioned earlier, I fully expect more volatility and at least one larger pullback this year and I think we will be able to get shares of Ford at that point at a fair price. 
 
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.
 
Sincerely,
Alan R. Myers, CFA
President / Senior Portfolio Manager
Aerie Capital Management, LLC
(866) 857-4095
www.aeriecapitalmgmt.com 

I have been reading a great book recently that touches on much of the psychology behind many of the investing decisions and errors that investors make.  The book, Thinking, Fast and Slow by Nobel prize winner Danial Kahneman, is a user-friendly narrative behind his thinking and research that led to the development of the field of behavioral economics.  One of the things Dr. Kahneman points out – and something I have been saying for a long time – is that we as investors are hard-wired to put a narrative to events.  This is an attempt to put order to an often random and chaotic world. 
 
We have had a volatile stock market since mid-September with any number of narratives to help explain what is going on and why investors are selling.  No, buying.  No, selling again.  First it was Chinese real estate developer Evergrande’s potential bankruptcy.  Then the Federal Reserve calmed fears by confirming what they have been saying all along – they will start tapering sooner rather than later and will follow that up with interest rate hikes.  Next it was hotter than expected inflation numbers.  So many headlines and so much confusion.  Let us try to sort this out a bit.
 
There are really two emotions that drive the market – fear and greed.  When fear is high enough, people will sell anything and everything.  Oftentimes financial advisors will talk about owning “uncorrelated assets”.  The idea is to own two different investments that will move in different directions when things get rough.  A simple example would be owning an airline stock and an oil company.  Since one of the major costs for an airline is their fuel costs if the price of oil increases this will hurt the airline’s profitability and presumably the stock price.  However, the oil company obviously benefits from this price increase as should their stock price.  The stock prices should move in opposite directions when the price of oil changes.  However, when fear rises, investors tend to ignore fundamentals and sell stocks indiscriminately.  We often see investors selling both their airline stocks and their oil stocks at the same time.  In “finance-speak” we would say that all assets have become highly correlated. 
 
The opposite effect occurs when greed is high.  Investors tend to rush out and buy regardless of the outlook or underlying fundamentals.  Oftentimes investors will create a narrative that justifies outrageous valuations.  Sometimes investors have no other choice.  This would explain the world of investing since the Great Recession.  The Federal Reserve lowered interest rates to effectively zero.  This was done to prod businesses to borrow money to invest in building new plants and buying new equipment to spur growth in the economy.  The economy did grow but never at the rate that anyone wanted nor expected though this should not have been a surprise.  Of course, one side effect of low interest rates is that people who rely on earning interest on their investments effectively earn nothing.  This forces investors to seek returns elsewhere. The only alternative has been to invest in stocks for growth and dividends and growth is what investors got. 
 
Since the 2009 post-Recession low, we have seen the stock market pull back on a few occasions.  There were often external forces or headlines at work, but the reality is that investors were just more fearful.  The first instance was in 2011 when Greece faced a debt crisis with the threat of bankruptcy and investors feared another 2008-like debt crisis.  This was also the first time the U.S. balked on raising the debt ceiling and credit rating agencies downgraded U.S. Government debt from an almost risk-free AAA bond rating to AA+ debt rating.  As a side note, as I write this, we are currently facing this very cliff again.
 
We again faced down fear in late-2015 through early-2016 when China’s growth rate was slowing, and oil prices were falling.  This proved to be a short-lived “crisis” as greed again soon took over and by March we were back to where we started.  Fear was stoked again in the fourth quarter of 2018 as we were embroiled in a damaging trade war with China and the Jerome Powell-led Fed raised interest rates for a fourth time for the year and indicated more was to come the following year.  Just a few days into January 2019, Powell was speaking to the American Economic Association and walked back the interest rate hike just a month earlier and indicated he was inclined to cut rates rather than raise them again.  Fear was erased, and greed took over again.  Lastly, there was, of course, the 35% losses sustained in March 2020 when the COVID-19 pandemic shut our economy down completely but by July all losses had been completely recouped as fear of an extended economic shutdown disappeared, replaced by hope life could return to normal sooner rather than later.
 
While the stories that have been spun during these corrections have all been different, the outcomes have been the same.  Fear in the short-term drives markets down until greed takes over and we are quickly at previous levels and higher.  There may also be a hint of “FOMO” – fear of missing out on gains.  In our current economic environment with very low interest rates, we remain in a “TINA” world – there is no alternative.  Investors who want any kind of return are forced to take higher levels of risk than might otherwise be prudent in a more normal world.  This is likely to remain the case until the Fed raises interest rates significantly.  Since the end of the Great Recession, investors have always been rewarded for “buying the dips”.  After one of the more recent pullbacks, I was chatting with a client about his worries over the markets.  He mentioned to me conversations he had recently with his son who actively trades options.  His son, my client told me, had urged his father to sell everything and “go to cash” until the market bottomed.  “That’s perfect!” I replied.  “And just when will the market bottom?”  His son had apparently not given him any figure for how far down he expected the market to tumble.  Our fear leads us to think that every time the market starts to tumble that it is different this time and the start of the financial apocalypse.  At some point, greed kicks in, we are afraid of missing out on future gains, we convince ourselves that stocks are ‘cheap’ again and markets correct themselves.    
 
What could raise the fear factor for investors enough to make a difference?  The biggest boogey monster currently is inflation.  The inflation rate is measured by what is known as the consumer price index or CPI.  The CPI measures the change in the price of a basket of goods and services typically used by a normal household.  The CPI is measured on a year-over-year basis.  Since we are now comparing prices this year to the same time last year when we were just emerging from the pandemic economic shutdown, you can imagine that prices have climbed dramatically as we return to a more normalized setting.  The inflation rate has been running “hot” as the economists say, with the CPI growing at an annualized rate of 5.4% per year.  This is the highest level since around 1990.  There are two questions about the current level of inflation.  The first question is how real this rate is and the second is how long this higher inflation rate last. 
 
There is some question about how realistic this current inflation rate is given that we are essentially comparing apples to oranges.  Of course inflation is higher this year.  Everything was shut down most of last year.  Oil, for example, is a component of the CPI and comparing the October 2021 price of oil to the October 2020 price of oil, the price is up almost 87% year over year.  If you go back a year and compare the current price of oil to the same period in 2019, however, the current price is up about 39% over the same 2019 period.  While that is a jump, it is not as significant a jump.  Personally I think inflation is higher than the Fed would like but lower than what the CPI indicates.
 
As for the question about how long this higher inflation could last, that question is a bit trickier.  Part of the reason for the higher inflation rate is the increased costs to businesses as shelves are restocked.  We have a supply chain issue, and this is driving both the inflation rate and the potential length of time for inflation to remain elevated.  When the pandemic hit, businesses around the world shut their doors to slow or halt the spread of the virus.  This led to empty store shelves as people panicked and bought a year’s supply of toilet paper and soup.  Most goods are now manufactured overseas, largely in China.  Now, as manufacturers attempt to increase production to get things back to normal, they are running into a shortage of enough workers to run the lines.  Assuming the goods get made and out the door, there can be a delay loading containers on the ships for export.  Once the ships arrive in the U.S., there is a backup of ships waiting to dock to unload and even if they get to dock, there is a lack of people to unload the ships.  Once unloaded, the goods are shipped out via railroad to be later transferred to trucks to be hauled to the stores.  Railyards are backed up with containers to be unloaded from trains and put on a trailer.  There is a lack of trailers and even if we had enough trailers, there is a lack of truck drivers.  All along the way, costs are added by shippers to cover these additional costs.
 
There is also a shortage of the materials used in production.  Auto manufacturers, for example, cannot get the microchips they need to build cars, forcing them to idle some assembly lines.  This has led to a shortage of new cars which drove up the prices for used cars as well as the cost for car rentals.  Businesses are having to pay higher wages to find workers for everything from the manufacturing line to the cash registers all of which will translate into higher costs.  Businesses will either have to accept lower profits or raise prices leading to contributing to the inflation picture.
 
Most economists thought the blip in inflation this year would be a relatively short-lived phenomenon.  Many, including Fed Chair Jay Powell, are now saying this higher inflation rate could last longer than first anticipated.  Some economists are arguing higher inflation is here to stay based on the increasing wages and unfilled jobs.  A few economists are evoking a blast from the ‘70’s – stagflation.  Stagflation is an economy in which growth is low or stagnant and prices are increasing at high rates.  Frankly, I am not worried about this scenario but just the very thought of the potential for stagflation to return raises a certain fear level among some investors. 
 
The more likely scenario is one in which the inflation rate continues at a relatively high level above the Federal Reserve’s target rate.  Chairman Powell has always maintained that he thinks an inflation rate of 2% per year is reasonable and healthy but he is willing to let the inflation rate “run hot” – that is to have an inflation rate above the 2% per year level – for a short span of time.  His view is that the rate should moderate over time.  The danger is that inflation runs hotter for longer.  If that were to happen, the Federal Reserve would want to reign this in.  The chief method the Federal Reserve uses to control high inflation is to raise interest rates. 
 
This scenario of higher inflation for longer should be the biggest fear for investors.  If inflation does continue at this hot pace, the Federal Reserve will be forced to raise interest rates both sooner and faster than they have intended or indicated.  As interest rates increase, this does two things.  First, it increases costs for businesses.  Second, it begins to create investment alternatives to stocks that may be more attractive.  If an investor is asked to choose between a stock paying a 2.5% dividend or a bond that matures in ten years paying 1.5% interest per year, the stock wins.  If I have the choice of a bond that is paying 3.5%, interest per year now I have a tougher choice.  Ultimately, many investors will abandon the volatility and risk of stocks for the relative safety of bonds, and this will drive the price of stocks down. 
 
This is a scenario that I am paying close attention to for client portfolios.  Across all client accounts, most of the mutual funds we own have been focused on “growth” stocks.  This has served us well as these are the stocks that have benefitted the most from this current environment.  These will also be the stocks that may suffer should this environment change.  Let me be clear.  I am not expecting an imminent or immediate meltdown in stock prices.  I do think we could see the S&P 500 Index eventually retreat from their current levels.  If the Fed is raising rates, this retreat would last longer.  With this expectation in mind, you will see me gradually cut back on our exposure to these growth mutual funds and reallocate to investments that are better positioned to weather the storm and continue to grow. 
 
This past quarter, we made a few changes across client accounts.  We sold off our holdings in homebuilder Lennar Corp. as valuations of some homebuilders are starting to get a bit stretched.  We also sold our holdings in food distributor SpartanNash, earning just over 6% return in about four months.  On the flip side, we bought shares in medical products and imaging supplier Hologic, Inc. (NASD: HOLX), diagnostics and testing company Quest Diagnostics Inc. (NYSE: DGX), regional supermarket chain Ingles Markets Inc. (NASD: IMKTA), and timberland REIT (real estate investment trust) PotlatchDeltic Corp. (NASD: PCH) which comes with a 3% dividend yield.  We were able to find more bargains during this more volatile quarter.  We also continued to make extensive use of options to enhance our returns – either by selling call options that obligate us to sell a stock in exchange for a premium or by selling a put option that obligated us to buy the underlying stock at the stated price.  Both strategies served us well during the quarter. 
 
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.
 
Sincerely,
Alan R. Myers, CFA
President / Senior Portfolio Manager
Aerie Capital Management, LLC
(866) 857-4095
www.aeriecapitalmgmt.com
​

The operating watchword for this past quarter was “inflation”.  We were preparing to hear from the Federal government on their measure of inflation and the only question was “how high”.  Prices have been steadily increasing as we slowly return to a more normal post-pandemic economy.  Everyone knew inflation for the first quarter of this year would be high.  After all, we were comparing current prices to the first quarter of last year when the economy was shut down.  We were comparing apples to oranges. 
 
The inflation rate for April came in a 4.2% and then rose to 5.0% for May, significantly above the 2.6% rate for March and the 1.2% average for all of 2020.  When the quarter started, the interest rate on a 10-year U.S. Treasury bond was 1.746% which was significantly above its pandemic low of a 0.538% interest rate.  This interest rate reflected investors’ fears that inflation was imminent, and the Fed might raise interest rates to combat this problem.  The key question argued between economists and investors was whether this high inflation rate was real and sustainable or, in the words of most economists “transitory”.  Federal Reserve Chairman Jay Powell is in the latter camp, which has led him to not react to these high inflation numbers.  Let me explain.
 
During a recession, no one is spending any money.  There is no incentive to spend now as prices are likely to fall tomorrow making the goods or services you want cheaper.  To spur spending, the Federal Reserve would lower interest rates.  The chief idea would be for businesses to see a low enough interest rate to incentivize them to borrow money to buy land, build new plants, buy new equipment, and hire more workers to “jump start” the economy.  This has been one of the main tactics during the past two recessions – the 2008 housing bubble and the recent pandemic economic shutdown.  The Federal Reserve lowered interest rates to basically zero on the shortest-term loans to drive investment.  It has not worked exactly as planned, but that is another story.    
 
On the flip side, when there is inflation in an economy, prices are rising, often rapidly.  When inflation exists, the incentive is to spend money now before it loses its value.  Inflation also drives people to borrow money now to buy big ticket items now (houses, cars, appliances) before their prices are out of reach.  If things get out of control, we have what is called hyperinflation.  The poster child for this phenomenon was Germany post World War I.  There are several stories out of this time about how quickly prices could change, even over lunch.  There is the story of a student at Freiburg University who ordered a cup of coffee at a café.  The price on the menu was 5,000 Marks.  He had two cups.  When the bill came, it was for 14,000 Marks.  He was told that if he wanted to save money and have two cups of coffee, he should have ordered them at the same time (from Paper Money by “Adam Smith”).  To stop inflation, the Federal Reserve would raise interest rates charged to banks, forcing banks to raise interest rates they charge their borrowers.  If interest rates reach a high enough point, it will “choke off” this borrowing and sanity will be restored to the economy. 
 
For anyone that lived through the high inflation of the late-1970’s and early 1980’s, the fear of high inflation is very real.  Let me be clear here.  I do not expect a return to those inflationary rates.  That was largely caused by the oil supply shock which dramatically and unexpectedly increased the price of oil very quickly.  This sent shockwaves through our economy which was largely built on using oil for everything from gas-guzzling cars to plastics.  And, to the point that I made earlier, this bout of inflation was finally reigned in when Fed Chairman Paul Volker dramatically raised interest rates and within three years brought inflation from over 13.5% down to around 3% annually. 
 
Circling back to the question at hand, are we facing increasing inflation or is it just transitory as many economists and the Federal Reserve seem to think.  Frankly, I believe that it is transitory.  We are already seeing the prices of many commodities that had soared in value coming back down to earth again.  We need only look to the futures markets to see this.  For example, lumber traded as low as $282.10 per 1,000 board feet in early-April 2020 during the pandemic, climbed as high as $1,733.50 in mid-May this year before falling back to $737.40 at the end of June.  We have seen similar moves in corn, wheat, copper, and most other commodities as well.  All these commodities are well off their recent highs set in mid-May.  If this is truly indicative of transitory inflation, the Fed is correct not to raise interest rates now as that could potentially choke off the recovery from the pandemic.  In fact, the Federal Reserve, in their most recent meeting, indicated they would most likely not be raising interest rates until 2023.  I am cautious on this expectation and would not be surprised to see a late-2022 rate hike.  I believe data may force them to move sooner than they want but, regardless, we still have at least a year of continued low interest rates fueling continued money flows into the stock market.  The key reason for this, as I have been saying for a while, is that this is a TINA world – as in ‘there is no alternative’ to stocks if you want to earn any return at all. 
 
All this fascination with inflation led to an interesting rotation in stocks for the quarter.  Many stocks that have been beneficiaries of the re-opening of the economy such as the airlines fell the hardest.  Stocks that gained for the quarter were heavily tilted to oil companies and industrial names, both of which tend to benefit from inflationary pressures.  I suspect the staying power of these oil and basic industrial stocks is as transitory as commodity prices have been.  Trying to time the markets by picking and choosing the ‘hot’ sector is a fool’s errand and something we avoid.  I prefer to find stocks that meet strict criteria and stick with them provided they continue to meet our standards for growth, quality, and potential long-term returns. 
 
We did a lot more trading this quarter than we normally like to do but most trades worked out in our favor.  During the quarter, we sold out of Beazer Homes USA (ticker: BZH) for a 23.73% gain, eliminated Cardinal Health, Inc. (ticker: CAH) with a small 4.17% gain, sold sporting goods retailer Hibbett, Inc. (ticker: HIBB) for a 53% gain, exited boating retailer MarineMax, Inc. (ticker: HZO) with a 60% profit and closed our position in construction firm Primoris Services Corp (ticker: PRIM) with a small 13% loss.  We sold either because the quality of the company had slipped in their recent earnings report, they were trading well above our estimate of a fair price, or their growth prospects were falling. 
 
On the flip side, we put some profits back to work, adding to our existing holdings in Atlas Air Worldwide (ticker: AAWW) as well as several new positions.  These new holdings include paper products company Clearwater Paper Corp. (ticker: CLW), two home décor stores, At Home Group (ticker: HOME) and Williams-Sonoma Inc. (ticker: WSM), apparel retailer Citi Trends, Inc. (ticker: CTRN) and RV dealer Camping World Holdings, Inc. (ticker: CWH). 
 
We also recognized that we had too much idle cash just sitting around collecting dust in many accounts.  Rather than let that continue to sit idle earning 0.01%, we bought an exchange-trade fund, the SPDR Bloomberg Barclays Investment Grade Floating Rate ETF (ticker: FLRN) that invests in short-term corporate bonds that have adjustable interest rates.  This will be beneficial when interest rates do finally start going up as the interest rates paid on these bonds will also increase resulting in higher dividend yields on this fund.  In the interim, the fund is paying a dividend of 0.21% on a “cash-like” investment.  It is important to note that this is not a guaranteed investment, and the value can and will change.  Typically speaking, the price of this fund will remain reasonably stable over the short-term.  This is not an investment in which we are looking for large capital gains.  We were looking for an investment that is reasonably safe, liquid, and earning something more than leaving the money in cash.  This fund fit that bill well. 
 
One last point on the cash management front.  One additional tool we have been using up until recently has been an options strategy called a “bull put spread” in client accounts.  This has often offered us a 10 – 11% return on the amount we were risking over the course of a month.  Basically, we were acting as an insurance company for people who thought the market might fall.  They might purchase insurance on their portfolios in the form of put options that would pay them cash if the market fell below a certain level.  We took the other side of that trade but to offset our risk, we would purchase insurance ourselves just a little bit lower in value.  For example, with the S&P 500 Index trading around 4,369, we might sell an option that obligates us to pay the holder if the index fell in value to 3,995 at expiration.  To offset this risk, we would turn around and purchase an option that would pay us if the index fell to 3,990, limiting our risk to the $5 difference between these two values or $500 in total.  To further mitigate risk, I typically limit the number of option contracts to only 1% of any individual’s account size, though some clients can afford to take a bit more risk.  This ensures that, even in the event of a market blowup, we won’t lose more than we can easily recover in a short time.  This strategy typically added over 2% or more to account performance over the first half of this year in those account where we have actively traded.  The key reason we have stopped doing this for now is that, with the complacency that seems to have settled over the markets, we cannot get enough premium to make this strategy worthwhile for now.  I am sure this will change again in time, and we will return to this strategy. 
 
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.
 
Sincerely,
Alan R. Myers, CFA
President / Senior Portfolio Manager
Aerie Capital Management, LLC
(866) 857-4095
www.aeriecapitalmgmt.com
​

What a difference a year makes!  This time last year, we were at the bottom of a long slide down though we didn’t know we had bottomed at that point.  Things looked pretty bleak, with millions out of work and businesses closed or closing.  Today we are in an entirely different place.  Vaccines are rolling out at a furious pace and over 51 million people have been fully vaccinated according to the most recent CDC data.  The most recent jobs report rose by over 900,000 which was well beyond expectations.  Job growth was strongest in leisure and hospitality, showing the “re-opening” trade is still very much alive and well.  The S&P 500 Index, a popular measure of the stock market, closed near its all time high and the first day of the second quarter closed above the 4,000 level for the first time ever.  The Federal Reserve is vowing to maintain interest rates at near zero levels and continues to pump about $120 billion into the economy each month.  Add to that the $1.9 trillion stimulus package Congress passed and the pending $1.2 trillion in infrastructure spending that is being negotiated and the economy is awash in money seeking investments.
 
Despite all these good numbers, there are a few caution signs flashing.  There are still about 8 million Americans unemployed relative to where we were in February 2020 before the pandemic hit and about 3.9 million fewer people in the labor force.  These folks that are out of the labor force are people that essentially lost their jobs during the pandemic and have indicated they have ceased to continue looking for a job.  As the economy continues to rebound, it will be important to note whether these folks attempt to return to the labor market.  In addition, it is not clear that we will be able to get the 8 million people still seeking jobs employment.  The pandemic did a lot to change the way we work.  Businesses have learned they can survive with fewer employees.  In addition, it is not clear that the jobs that are needed line up with the skills of those who are out of work, making the jobs recovery more challenging. 
 
We have seen interest rates climb rather steeply since the start of the year.  This has taken a little bit of wind out of stocks’ sails and has raised fears of inflation and even higher interest rates.  Before we start panicking, let me address this issue.  During the pandemic, interest rates hit historical lows, largely because no one was borrowing for any reason.  One of the key benchmark rates has been the interest rate on the 10-year Treasury bond – that is, a bond issued by the U.S. Government that matures in ten years.  Before the start of the pandemic, the interest rate on these bonds ranged between 1.65% and 1.95% before plunging to an historical low of 0.53% in July.  We are now back around the 1.65 – 1.70% range so this is not anything to either be surprised about nor alarmed at either.  This is just another sign of markets returning to pre-pandemic normality.  The big worry will be if this rate continues to creep up well past 2%, making bonds more attractive than stocks. 
 
The rise in interest rates and with a focus on the vaccine rollout and the economy getting back to normal, we saw a shift in investors mindset.  This led to a change in investor sentiment from what many pundits described as moving from “growth” to “value”.  A better way to explain the shift in investor sentiment would be to say it moved from technology and high growth to infrastructure and lower growth.  When you look at the best performing stocks in the S&P 500 Index for the first quarter it is filled with energy (ExxonMobile Corp), materials (Nucor Corp) and industrials (Deere & Co.) while the worst performing stocks included a lot of information technology stocks (Apple Inc), health care (DaVita Inc.) and consumer discretionary (NIKE Inc.).  This shift in sentiment both hurt and helped us during the quarter. 
 
Many of the mutual funds we hold across client accounts are very tilted towards ‘growth’ which typically means a higher allocation to technology names and the stocks that have done well through the pandemic.  With the change in sentiment recently, many of these funds have stalled and lagged the broader stock market over the quarter.  We have still done very well over the past year and I expect these funds to continue to perform well providing they continue to find sectors that are growing.  We did make one change right at quarter-end, paring back dramatically on the Putnam Growth Opportunities fund (POGAX) in many client accounts.  The accounts we trimmed also held the Janus Henderson Balanced Fund (JABAX) as our “core” holding.  As it turns out, the Putnam fund and the Janus fund duplicated each other across most of their top holdings.  This exposed us to too much risk especially in the tech sector.  We chose to cut the allocation to the Putnam fund in half, which dramatically lowers the risk we are taking in client accounts.  Please note that I am not saying that either fund was “bad”, just that having both funds in the same account meant we were too exposed to some stocks.  The other mutual funds we hold continue to do well and we will continue to monitor them and make changes as appropriate.
 
We benefitted from the shift in sentiment through many of our individual equity holdings.  Most of the individual stocks we own are in far less glamorous industries.  We do have a reasonably large bet on the housing market given our exposure to Tri Pointe Homes (ticker: TPH), Lennar Corp (ticker: LEN) and Beazer Homes USA Inc (ticker: BZH) which we added this past quarter.  Other new purchases we made this quarter were also in rather mundane industries.  We added Primoris Services Corp. (ticker: PRIM) which is involved in building and maintaining pipelines, gas, water and sewer systems for cities and infrastructure construction.  Another new purchase for the quarter was Atlas Air Worldwide Holdings (ticker: AAWW) which buys and leases aircraft for everything from charter flights for tours to freight forwarders and e-commerce retailers (think Amazon here). 
 
The key question at the end of a quarter is always “what comes next?”.  At the risk of being redundant, I am still cautiously optimistic.  I know I say this seemingly every single quarter, but it remains true.  I believe many of the more popular stocks are overvalued, but I also think we are still in a TINA world – there is no alternative.  Much of the stimulus money from last year already found its way into the markets and I suspect much of the recent $1.9 trillion stimulus package will soon find its way into stocks.  I remain convinced the market is essentially in a “liquidity bubble”.  The only reason for the current stock market valuation is the extreme amount of liquidity due to stimulus money and the Federal Reserve.  The Federal Reserve is contributing to this bubble by purchasing $120 billion worth of bonds every month.  I am convinced this will continue as long as the Fed continues down its current path.
 
We have already seen a couple of attempts in past years by the Federal Reserve to either cut back on buying bonds or to raise interest rates.  The first attempt to cut back on the bond buying in 2013 did not end well.  When the Federal Reserve finally stopped the program in October 2014, the market largely ignored the event.  Many pundits compare ending this bond buying program, officially referred to as “quantitative easing” or QE, as taking away the punch bowl in the middle of the party.  The most recent round of QE was begun in September 2019 and ramped up in March 2020 in response to the COVID pandemic.  The only time interest rate hikes have not gone over well was when current Fed Chair Jerome Powell raised interest rates for the fourth time in December 2018 and indicated he expected two or three more hikes in 2019 which was not what the markets wanted to hear.  After markets fell precipitously, Chairman Powell quickly reversed course. 
 
With this background, I would not anticipate Fed Chair Powell stopping the bond buying or raising interest rates at any point before 2022 at the earliest.  In some recent testimony before Congress, he has gone so far as to indicate he is unlikely to do anything until 2023 based on his current projections.  Frankly, the artificial inflation of our economy is not sustainable.  As much as I understand the underlying principles involved, the diehard Keynesian in me says that enough is enough and as we get back to normal, we need to run balanced budgets and pay off debts.  How this situation ends remains to be seen but that is likely some time down the road.  For the short to intermediate term, our best course is to stay focused and not panic when we have small market corrections.  For just over the past decade, the best course of action has been to “buy the dips” and until mindsets change in Washington, this will continue. 
 
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.
 
Sincerely,
Alan R. Myers, CFA
President / Senior Portfolio Manager
Aerie Capital Management, LLC
(866) 857-4095
www.aeriecapitalmgmt.com