First of all, I hope this letter finds you and your family safe and sound and healthy during this pandemic. With that said, let us dive in to this past quarter. We officially entered a recession in February which ended the longest expansion on record that started in 2009, 128 months ago. This recession may turn out to be the shortest recession on record but that remains to be seen. The prior record for the shortest recession was six months back in 1980. Whether we quickly end this recession or not depends upon controlling the coronavirus.
During May and June, we saw unemployment drop from 23 million in April to just over 17 million by the end of June. The official unemployment rate fell from 14.7% to 11.1%, which was somewhat of a surprise. Most of this growth came from the retail and restaurant sectors as states attempted to restart their economies. This “growth” may be transient, though, considering the ever-growing coronavirus cases across the country. As the accompanying chart shows, we were just starting to head in the right direction before quickly turning and heading in the wrong direction. This could be problematic. Many states are especially hesitant to go backwards and close their economies down to stem this rising spread of the coronavirus. They may not have a choice, though. The one thing that could allow businesses to continue to operate is if more people wore masks. However, this has become a political issue more than a social or economic issue. This should never be a political or partisan issue.
All of this puts the U.S. economy in a very fragile space. Do we “damn the torpedoes, full speed ahead” with the economy and risk a much higher number of deaths or do we pause or even go backwards on the reopening of businesses in order to reduce the number of positive cases and hopefully contain the virus until a cure or vaccine is found? Add to this a President who is up for re-election and had planned to run on a strong economy until the coronavirus hit. He is now more determined than ever to get back to where we were in January and February and that could be dangerous.
In the face of this conflicting data – strong unemployment numbers coupled with rising coronavirus cases throughout the U.S. – the stock market has been stellar. So far. The Fed announced major stimulus on March 23 and over the next three days, the stock market rallied for a 17.6% gain, the largest three-day advance in more than 80 years. By early-June, the market was up almost 45% above the lows of March and within 5% of the all-time high that was hit in late-February. The index gained 19.95% for the quarter. It was looking like those who predicted a “V” shaped recovery were correct. From the numbers put up by the S&P 500 Index, it would seem that things are going well. However, when you dig a little deeper into the returns of the 500 companies that make up this index, you find a slightly different story.
It was really two sectors that drove this surge in the S&P 500 Index. One was technology, up 30% for the quarter. This was driven primarily by Microsoft and Apple which together make up 41% of this sector. The consumer discretionary sector also gained 30% driven largely by Amazon.com which is 23% of the sector’s weighting. This sector also did well thanks to investors buying riskier investments such as restaurants, cruise lines and home builders.
One of the best examples of how crazy investors went this past quarter is probably encapsulated in the shares of Hertz stock. Hertz, the auto rental company, has about $20 billion in debt. Most of their rental business took place at airports and with air travel down 80% or more from a year ago, no one was renting vehicles. In early-May, the company requested forbearance on their debt and then on Friday, May 22 Hertz filed for bankruptcy after the close of the trading day. The stock had closed at $2.84 per share on that day. On the following Monday, the stock traded at $0.55 per share as, even by the company’s own admission, shareholders were likely to walk away with nothing in the event the company did manage to restructure.
Within two weeks, speculators had driven the price of Hertz stock up from $0.55 per share to $5.53 per share on pure hope. The company continued to point out their stock was essentially worthless but nonetheless filed to sell additional shares of stock to raise an additional $500 million given the sharp spike in the stock price. This plan ultimately died but this was the risk appetite of investors this past quarter. Investors were buying regardless of the risks or prospects for companies to recover.
With this “risk on” mentality, let us dig just a little deeper into the performance of the S&P 500 Index. First, let me explain that this index is what we called “market cap weighted”. Market capitalization or market cap for short is simply a calculation of the total value of a company’s stock. You take the price of the stock at any one moment in time and multiply by the total number of shares of stock the company has sold (called “shares outstanding”) to get the market capitalization. The S&P 500 Index “weights” each company in the index by its market cap. In other words, the company with the largest market cap carries the most weight and the company with the smallest market cap has the least influence on the index’s value. Currently, the top five companies by market cap weighting are Microsoft, Apple, Amazon.com, Facebook and Alphabet (Google) with these five companies comprising 20% of the index.
It is instructive to look at an equal weight index of this index in comparison. In an equal weight index, no component initially carries more weight than another. The five companies listed above currently make up 1.06% of the equal weight index. During the past quarter, the equal weight index did slightly better than the market cap weighted index. This is easily explained by investors who took on more risks buying cruise lines, airlines, and bankrupt companies which carry less weight in a market-cap weighted index. However, since the start of the year, the equal-weighted index still lags its market-cap weighted brother by a noticeable margin. The accompanying chart shows the returns of the S&P 500 index (red line) versus the equal weight S&P 500 Index (green) since the start of the year. The market cap weighted index is down 4% while the equal weight index is off by over 12% through the end of June. The outperformance of the market-cap weighted index is concentrated in the performance of a few tech names that exert far more influence. The bottom line here is that most stocks are not performing nearly as well as “the market” might make you think.
With most stocks still down 12% for the year and coronavirus cases surging, I am not terribly worried about a major meltdown. You might wonder what has caused me to lose my mind like this. I assure you I am no Pollyanna, seeing unicorns and rainbows where there are none. I am very worried about states that may have tried to restart their economy too soon. I am very worried about the rapidly increasing infection rates and the potential for many businesses to have to close again and for another round of layoffs.
The one thing that allows me to sleep just a little better at nights is the Federal Reserve. The Government has stepped up with over a trillion dollars in stimulus through $1,200 checks or a $600 “bonus” in unemployment pay. These measures have helped ease the economic damage caused by the coronavirus in the short run. However, the government’s response is somewhat limited and must move through both houses of Congress and the President’s desk. The Federal Reserve can act relatively quickly, and they have. They have lowered interest rates back to zero and they have stepped in to buy back bonds. This last measure is where I find comfort. The Federal Reserve has been actively buying bonds for years. Post the Great Recession, the Federal Reserve undertook a program they called “quantitative easing”. This entailed buying government bonds from the public. This put cash in the hands of investors. The hope was that investors would take this cash and invest it by starting a business or buying a piece of equipment to improve production or build another plant. Instead, this cash found its way back into the stock market. Investors bought stocks, which drove the stock market up over 500% from the lows of 2009 through the peak in mid-February.
I mentioned earlier the stimulus the Fed announced in late-March that led to an almost 18% rally in stocks. Following on the heels of that announcement, the Federal Reserve has stepped with even more money. They have offered to buy not only government bonds but now they have stated a willingness to buy corporate bonds, junk bonds and even bond mutual funds in the form of ETFs or exchange traded funds. All of this serves to essentially put a “floor” underneath the markets. Does this mean that we cannot have stocks sell off? Of course not. The Federal Reserve is not going to try to stop every dip, but they have signaled a willingness to step in when things get rough. This psychological floor should help sustain stocks’ upward momentum, at least for the short term.
With all of that as a backdrop, we made a few trades over the course of the quarter. We added two new stock names to client accounts. The first was Astec Industries (ticker: ASTE), a manufacturer of heavy road equipment and the other was ACCO Brands (ticker: ACCO), which makes and distributes office and school equipment (think Swingline staplers or Mead notebooks). In addition, we added two new mutual funds to client accounts. I had mentioned the Virtus KAR Midcap Growth (ticker: PHSKX) fund in my previous letter, and we did start adding that to client accounts in early April. We started purchasing shares for $37 per share and by the end of the quarter, this fund was trading for over $52 per share for a 40% gain. We also added the Putnam Growth Opportunities fund (ticker: POGAX) to client accounts as well. This fund, which currently leans heavily on technology stocks (Microsoft, Apple, Amazon.com and Alphabet account for almost a third of the fund’s holdings) was added starting in late May to client accounts. I intend to keep a close eye on this fund, as I am beginning to worry about a potential bubble in these tech stocks.
We did eliminate our holding in the T. Rowe Price International Discovery (ticker: PRIDX) fund this quarter. This is a good fund for exposure to smaller, growing foreign companies but with the coronavirus situation across the globe, we felt the risk was entirely too great and the better opportunities were here in the U.S. Towards the very end of the quarter, we added options on the S&P 500 that will benefit if the value of the market falls. I know that I said earlier that I expected the Federal Reserve to “backstop” stocks to keep them from melting down too far. The options we own protect us in the event of a 10% drop from where the market closed out the quarter. Even if the Fed is willing to step in, the uncertainty surrounding the coronavirus, businesses potentially having to reclose creates too much uncertainty and the risk for a sudden, sharp drop. I consider this to be “insurance” against a short, sharp correction. These options should protect us through late-August.
I had truly hoped that things would be much different with the coronavirus situation at this point. Given the increasing cases currently happening around the country, I will again forego in-person meetings with clients to help keep everyone safe. However, that does not mean we cannot meet face-to-face. I have added GoToMeeting, a video conferencing software to my repertoire. Last quarter I mentioned that I had added Zoom. Shortly after doing that, I learned of Zoom’s many flaws that allowed hackers through. Rather than risk my computer being compromised and client data being lost, I chose to delete that program and move to one that I know to be more reliable and safer. If you would like to schedule a meeting with me, please feel free to either email me or call me and I will set this up and send you the invite to the meeting. As always, we genuinely 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.
Alan R. Myers, CFA
President / Senior Portfolio Manager
Aerie Capital Management, LLC
What a wild quarter we have just finished! This quarter was a tale of two completely different years. You can almost literally split the quarter in half. The first “half” lasted until February 19 when we hit the all-time high on all the major indexes. The S&P 500 Index hit 3386.15 for a 4.81% gain since the start of the year. Then, things changed. Gradually at first. Then it picked up speed. Rather than try to discuss them here is a list that summarizes the “second half” of the quarter:
No matter how you slice it, this has been an unprecedented time for the markets. Some of what has happened was predictable. Some was not. I don’t think anyone realized just how dramatic and quick an effect the pandemic would have on our economy. Add in the oil shock from the Saudi Arabia – Russia feud that led to a collapse in oil prices and we are in a recession. Officially, we aren’t – yet. However, when we look back, we can point to February 20 as the start of the recession. And some pundits are even beginning to use the “d” word – depression. Let’s parse all of this and see how we arrived at the end of the quarter and where we go from here.
The biggest issue currently, of course, is the coronavirus pandemic. This was first identified in Wuhan province in China in 2019 and the first case on U.S. shores occurred on January 21 in Washington state to a man who had traveled to Wuhan. China imposed strict lockdowns in Wuhan. These severe restrictions dramatically limited the disease from spreading throughout the rest of China. The rest of the world has not been so lucky. Even though President Trump restricted travel from China there were exceptions and 40,000 people have arrived here since the restrictions were imposed.
By mid-February, the official name of the disease became COVID-19 (“Co” for coronavirus, “Vi” for virus, “D” is for disease and “19” for the year it was first identified). On February 26, a case of COVID-19 was diagnosed in California from a patient with no known travel history to an infected area and no know contact with anyone diagnosed with the virus. This is the first instance of what is called “community transmission”. Essentially, community transmission means a person gets the disease from a source that is unknown. Think back to that old shampoo commercial where the girl says she told two friends who told two friends and so on and so on. The fact that a person could be a carrier of the disease and not know it really became a game changer. Three days later, on February 29, we had the first COVID-19 death in the U.S. By March 17, all 50 states reported at least one COVID-19 case.
The community spread aspect of this disease has led to many states imposing lockdowns on travel and gatherings, limiting gatherings to no more than 10 people and forcing many businesses such as restaurants, bars, gyms and theaters to close. Only those businesses deemed ‘essential’ are allowed to operate. Many restaurants have fallen onto delivery or carry-out only mode in order to try to survive this pandemic and shutdown. Travel has fallen dramatically with the number of airline passengers plunging 90% in one month. Cruise ships are idle. Jobless claims – those people filing for unemployment benefits – jumped from around 200,000 per week through January and February to 6.65 million the last week of March. The 6.65 million claims number is an all-time record. And we may not be done yet.
I expected the coronavirus to influence our economy. If you look at the email I sent out on March 1 (posted on our website at www.aeriecapitalmgmt.com/blog), you will see that my cautionary note was dependent upon how quickly we managed to contain the virus. I naively hoped we might get a handle on the virus with two or three weeks. In my defense, two weeks later I fully admitted that we were way behind the curve and very unprepared for this pandemic. That along with the oil shock had tilted us over to a recession, I argued. I still believe that to be true. I still believe our economy is resilient enough to bounce back from this coronavirus shutdown. Policy makers are responding. The Federal Reserve slashed interest rates to essentially 0% and is planning on pumping $1 trillion into the economy by buying back bonds from investors. This will have the effect of adding cash to our economic system. Add to that the $2 trillion stimulus package that was rushed through Congress this will help cushion the blow. But it may not be enough.
I mentioned the oil shock both in the second email I sent this past quarter and above. To recap, essentially Saudi Arabia and Russia walked away mad at each other over attempts to negotiate lower oil production in order to achieve higher oil prices. Everyone went home on a Friday with oil selling for about $41 per barrel. When oil traders walked in the following Monday, it was selling for $31 per barrel. This was a crushing blow to the U.S. shale oil business. Most of the companies in Texas and the Dakota’s need for oil to trade above $32 per barrel in order to break even. Oil slid to as low as $20 per barrel by the end of March. This has been exacerbated by the shutdown of our economy. With most states issuing “stay at home” orders and commerce shutting down the demand for oil and oil products (i.e. gasoline, jet fuel) is at a low. This is resulting in a glut of oil. Normally, low oil prices would normally be a boon to our economy. However, there are some major drawbacks to this current situation. As I mentioned, oil companies need a higher price just to break even. To make matters worse, many of these companies are very heavily indebted. To adjust to the current situation, many have cut back on projects. This means companies that provide the drilling equipment and manpower are having to cut staff. This is on top of any coronavirus layoffs, of course. Unless oil prices rise again, there are going to be bankruptcies in the oil patch.
If we really are in a recession, what is our plan of action and how are we currently sitting during this whole crisis? When, if ever, will this end? Let’s start at the end. If China is any indication, they locked down the Wuhan province January 23 and by March 19 they were reporting no new cases. This would argue that we have a two-month shut down in front of us if we really want to gain the upper hand on this virus.
I did address some of what I was doing in my second note. We did manage to control risk across client accounts, falling less than the broad market. I have shifted the focus a bit from “growth” to “defensive”. Defensive means we are not fully invested but we are gradually easing back into the market. Sometimes I use creative ways to do this. For example, I sold an option that obligates us to buy shares of Southwest Airlines (ticker: LUV) for $30 per share. For this obligation, which expires the middle of April, we collected $3.40 in premium. Now, if we end up having to purchase shares our actual cost is $26.60 per share which is quite a discount from Southwest’s actual value. If we don’t end up buying the shares, we have earned over 11% return on the money we have set aside for the purchase. Either way, we win.
In addition to selectively looking to add names, we are also reevaluating our current holdings. Warren Buffett once famously said ‘When the tide goes out, you get to see who’s been swimming naked.’ What he was referring to is that during a bull market when investors are ebullient, just about every stock or equity mutual fund will rise. You could pin the stock quote pages of the Wall Street Journal to your wall, throw a dart and buy whatever it hits and make money during a bull market. It is when a crisis hits, and stocks sell off that we see who was was doing a good job of anticipating and controlling risk. We have been going back over many of our holdings to see if any have been swimming naked. As it turns out, one probably has been. The Parnassus Mid Cap Fund (ticker: PARMX) really underperformed what I thought its performance should be. You can expect to see that fund disappear to be replaced by the Virtus KAR Mid-Cap Growth Fund. This new fund managed risk amazingly well during this volatile period and also has a great long-term track record.
We did sell a few of our holdings during the quarter, but most were sold prior to the market meltdown. We eliminated Kenon Holdings (ticker: KEN) based on valuation for a nice profit; PetroBras (ticker: PBR), the Brazilian oil giant was sold prior to oil tumbling; and we sold out of Seaspan Corp (ticker: SSW) based on the company’s move into a completely unrelated business. We sold the Seaspan just as the market started its free fall but still managing to lock in nice profit.
We didn’t add much during the quarter. The largest addition was a new bond mutual fund, the T. Rowe Price U.S. Bond Enhanced Index Fund (ticker: PBDIX). This is a compliment to the Janus Henderson Multi Sector Income Fund with a bit less risk. We also added to our current position in our two core holdings, the Janus Henderson Balanced Fund (ticker: JABAX) and the T. Rowe Price Capital Appreciation Fund (ticker: PRWCX), as markets fell. These balanced mutual funds, which hold both stocks and bonds, were a way to dip our toes back into investments without taking a lot of risk.
Looking ahead I am still cautious. As I have been writing this letter, markets seem cheered by good news around the COVID-19 situation. Deaths are apparently not going to as high as feared. China is reopening travel in the Wuhan province. All seems right with the world. Except that it isn’t yet. Even if businesses are able to reopen after two months we are not going back to life before coronavirus. People will still need to keep some distance. We still have no natural immunity to this very contagious and deadly disease. Even if we get a break over the summer, COVID-19 is very likely to return for a second wave later in the fall or winter. This could mean another round of shutting our economy down. Until we have either a treatment for COVID-19 or a vaccine against it this will remain a situation that will bear close monitoring.
Earnings for the first quarter are expected to start coming soon. Expect those earnings reports from companies to be bad. Expectations are for earnings to decline 5.2% for the quarter. Estimates for the broader economy are still slightly positive with the estimate for our GDP (Gross Domestic Production – a measure of all the goods and services produced by our economy) to fall to a 1.5% annualized growth rate with unemployment spiking to 6.5% from its current 3.7% level. Looking ahead the expectations are for the second quarter GDP growth to be very negative with a slight improvement in the third and fourth quarters. Of course, that improvement depends upon no return of COVID-19 and no additional shutdowns. I tend to be a bit skeptical about that assumption.
You can expect us to be cautious. I will take advantage of investment opportunities as they arise. I will continue to be cautious about adding new positions and will take profits or sell into rising markets when appropriate. I am paying close attention to any news around treatments or vaccines for COVID-19. These will greatly influence how and when our economy manages to rebound. You can expect the increased level of volatility in the markets to continue for some time to come. While this can be a bit stomach-churning at times it also offers up opportunities for profits.
As I close, I wanted to let you know that with the current coronavirus situation, I will not be traveling to see clients this quarter. However, that does not mean we cannot meet face-to-face. I have added Zoom, a video conferencing software to my repertoire. If you would like to schedule a meeting with me, please feel free to either email me or call me and I will set this up and send you the invite to the meeting. 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.
Alan R. Myers, CFA
President / Senior Portfolio Manager
Aerie Capital Management, LLC
I have started this note at least three separate times and each time something happens that changes the tone of what I want to write. I know this is a very scary and confusing time for everyone. It seems like our world is about to come to a halt. Nothing could be further from the truth. Amid this maelstrom, we need to remain calm and think rationally. I would like to let you know what I am seeing and thinking about our current economic situation.
I wrote to you just a week and half ago regarding the volatility we were seeing the markets at that point. At that time, I indicated that the COVID-19 coronavirus epidemic was a serious event but that much depended upon how we and the rest of the world managed to contain the spread of the virus. I felt that if we managed to effectively gain some measure of control, this market turmoil would turn out to be little more than a market correction. In the interim, we have had more information to come out – both about the epidemic or pandemic now as the WHO has labeled this crisis and in the completely different world of oil. Let me address each of these separately and then bring the two together.
Looking at the ongoing saga of the COVID-19 coronavirus, it turns out that the U.S. is behind the curve in containing the virus. One of biggest issues was a severe shortage of test kits available in the U.S. to test people who may have been exposed to the virus. There were several failures along the way here but pointing fingers and trying to lay blame does not resolve the situation. The truth is the U.S. was ill-prepared for the virus to hit our shores and the current administration attempted to minimize the severity of the situation, likely to prevent a panic. That has obviously backfired spectacularly if the stock market is any indication. As President Trump spoke on Wednesday night, in an attempt to offer up solutions to deal with the virus and the economic fallout, the futures – the expectation for how the U.S. stock market will trade the following day – moved from up 200 points to down 1,100 points. This shows a remarkable lack of faith in our government’s response to the crisis.
In its defense, the U.S. has ramped up production of test kits. They are more available now, but we are currently only testing people who are walking in to clinics or hospitals complaining of possible symptoms. If we want to contain this virus, we need to do far more testing. We can stem the tide by finding those who have milder symptoms and are contagious to stop them from playing “Typhoid Mary”. We can also keep social distances, avoiding large crowds and staying home when sick. How all of this will play out, I have no idea but that is not my job. Rather, that is something that I had expected to hear from our President.
Before I get to my next point, I want to be clear that I am not a doctor, nor do I play one on TV. However, I do know some doctors and I went straight to one of them for information on the COVID-19 novel coronavirus. Coronaviruses have been around for a while, but what we are seeing now is a new strain of this virus that has never been seen in humans before. That is why we call it a “novel” coronavirus and the “19” indicates the year it was first diagnosed in humans. The symptoms around this novel coronavirus include runny nose, sore throat, cough, fever and difficulty breathing. Since this is a new mutation of the coronavirus, no one has any natural immunity to the virus making this very contagious.
This is where the media steps in to whip up the fear. Based on the number of people who have died from this virus here in the U.S. relative to the number of diagnosed cases, you might think the death rate is north of 5% of the population. If you look at the death rate in China, where this virus was first diagnosed, it was around 3.5% of the population of diagnosed individuals. And that last part of the sentence is the key part – diagnosed individuals. In large part, only people who showed symptoms were tested. We don’t know how many more people had the virus but it passed reasonably quickly and without major incident for them. South Korea may be a more accurate picture of what we can expect. South Korea tested over 140,000 people and the death rate from those with the coronavirus was around 0.6% of the confirmed cases. This was because more people had been exposed to the COVID-19 coronavirus than anyone thought, but many of them had more mild cases which cleared up with time and treatment.
I do not want to minimize the risks of this new virus or dismiss the need to take precautions. While the media is busy hyping the severity of this virus, many are screaming and pointing to the flu and saying “but what about…” Both are serious business. There are key differences, though. One is that there are vaccines to help control the flu virus. In addition, most flu viruses have been around long enough that many people have built up a natural resistance to them. Since this novel coronavirus is a new strain no one has any natural immunities built up yet. Also, with no vaccines to help control it, there is a real risk of it spreading rapidly and widely throughout the population. With a still limited number of test kits available currently, getting diagnosed will largely depend upon whether or not you have traveled to a region of the U.S. or world where the virus is prevalent or whether you have been exposed to someone who has been diagnosed with the coronavirus. As per my source, if you have milder symptoms, stay home and call your doctor. If you have slightly more severe symptoms – fever, cough – you might seek out a walk-in clinic. Leave the ER visit for those who are at the most risk.
And that last part is where we do need to be concerned and a bit alarmed. One of the biggest issues around this coronavirus is the constraints on our healthcare system. Since this is a highly contagious virus, many people are likely to be infected. The people who are most vulnerable are the elderly and those with compromised immune systems or chronic health issues. If this spreads rapidly enough, the number of people needing to be treated could overwhelm our healthcare system. You could potentially have dozens of people walking into an ER or clinic that is operating short-staffed because a number of the healthcare workers are home with the coronavirus themselves. In addition, if the patients coming to the ER need treatment due to already existent health issues, there is a very real possibility of a hospital not having the room or proper facilities to treat that patient as their equipment may be already tied up with someone else.
It is for this reason – the need to slow the spread to keep from overwhelming our healthcare system – that events are being cancelled and businesses are urging employees to work from home. This “social withdrawal” is one of the best ways to slow the spread of the coronavirus. Following such procedures as washing your hands and not touching your face will also help. I still believe the damage to our economy from having the NCAA tournament cancelled or the cancellations of festivals and conferences will be a short-term blip. The economy may show zero or even negative growth for a quarter or two, due to measures now being taken to control this coronavirus, but we can and will recover quickly from this setback.
The bigger issue for me came last weekend when Saudi Arabia suddenly reversed course on trying to limit oil production in order to bolster the price per barrel. Essentially, the OPEC nations and Russia were in discussions on ways to cut production and keep the price of oil at a reasonable level for all of them. There were some disagreements on the level to be supported and Russia and Saudi Arabia both walked away mad. To get even, Saudi Arabia immediately lowered the price of oil they are offering to sell to China by $6 per barrel, undercutting Russia and effectively cutting them off. This led to a very severe drop in the price of crude oil as it fell from $41 per barrel on Friday to $31 per barrel last Monday. Why is this concerning? After all, lower oil prices will mean lower gas prices at the pump and that is a good thing for the economy, isn’t it? Well, yes that part is good, but the timing is terrible and such a dramatic fall has repercussions well beyond lower gas prices.
This is, in part, where the two stories – the coronavirus and the oil shock – come together. While lower oil prices will lead to lower gas prices, it is coming just at a time when events are being cancelled or postponed. The lower gas prices will have only a marginal effect on the economy if most people end up “self-quarantining” themselves to slow or prevent the spread of the coronavirus. If the oil war continues through the summer, this offers a small benefit to consumers. However, the longer this oil war drags on the worse it will be for oil companies.
Many U.S. oil companies are very highly leveraged, meaning they have borrowed a lot of money over the years. Many of these companies need for oil to sell for $32 per barrel in order to at least break even. Above that price, these companies make money. Below that and we have serious trouble. If oil remains at $30 per barrel or less, some of these oil companies will start trying to cut costs to save money. This will mean reduced drilling efforts which will mean some employees and suppliers will lose jobs and money. Eventually there will be layoffs and that will lead to layoffs by businesses that rely on the money these workers bring in.
I mentioned in my last update that I was not terribly worried about a long-term economic impact from the coronavirus. I felt any impact would be sharp but short-lived. I felt – and still feel – that companies will return to business as usual in short order as panic over the coronavirus gradually fades. Yes, Disney is closing its theme parks for a couple of weeks, but do you really think people will stop going to Disney as summer rolls along? It may take a few more weeks after reopening for people to venture back out. Eventually the parks will be packed again, and Disney’s earnings will return to normal. What I did not count on in my last note was the oil war that exploded almost literally overnight. That, along with a weak response to the coronavirus here in the U.S. has changed my outlook. I am now expecting a recession if we are not already in one. The thing with recessions, it is usually only after economists look back on key numbers that we recognize when they started.
Given this change in my outlook, I will be making some changes to client portfolios. I will be shifting from a focus on “growth” to a focus on “defensive”. Most recessions can last from twelve to eighteen months. Just because we enter a recession does not mean that stocks will not go up in value. There will always be companies that will benefit from the trials and tribulations of others. As I mentioned in my last note, I was already preparing a shopping list. Honestly, it wasn’t until I changed my focus on where I wanted to look for stocks that I was able to begin to find any value. This does not mean that you should give up on stocks completely. Over the longer term, stocks will do far better than any other asset class. As I mentioned before, for many of you that are in retirement, we have four years’ worth of your required minimum distributions in bond funds. This buys us the time to allow the stock portion of the account to bounce back. If you are not in retirement and not close yet, this is a time to think about investing more. If you have a 401(k) where you work, perhaps increase your contribution and “stay the course” with an allocation you are comfortable holding. At the very least contribute enough to get your employer’s maximum matching contribution if they offer that benefit. If you are maxing out your 401(k) contributions, consider IRA’s or even taxable accounts. Buying when things look bleakest leads to the biggest gains when all looks brightest.
If you are close to retirement – within the next two or three years – or if you are worried by the market volatility, perhaps you should consider changing your allocation. If you have specific questions about how to reallocate or just want to talk through whether you should reallocate your account, please feel free to call me or email me at your convenience.
As one last side note, when I started writing this note it was in the middle of the day when we were experiencing a 9% loss and one of the largest sell offs since the 2008 financial crisis. As I finish writing, we have bounced back by just over 9% for the day, one of the biggest up days since the 2008 financial crisis. Please do not think things have changed for the better over night and we are heading back to new records. I fully expect more volatility in the days and weeks to come. There will be news of companies losing money or potential bankruptcies that will roil markets. There will be successes like Congress passing a bi-partisan bill that helps cover many of the shortfalls for people out of work due to the coronavirus. The bigger key is whether we bounce back quickly and, more importantly, how things play out with oil and the oil companies. I do have a shopping list of stocks I would love to buy, and I am constantly updating it with new information. This list will likely change over time and I am in no hurry to buy just for the sake of buying. As Warren Buffett has pointed out, we don’t have to swing at every stock that is pitched at us. We can patiently wait for the “fat pitch” that is easily knocked out of the park. And, switching metaphors, just because we miss one investment train is no reason to get upset. There will be another one coming along at some point.
By now, everyone is probably aware of two things – there is a new disease called the Covid-19 coronavirus and it is not caught by drinking Corona beers. The stock markets fell 12% in just four days which was a record and the worst week since October 2008 during the financial crisis. These two events are very much related. I just wanted to touch base with you to let you know what has happened and what we are doing around this situation.
In my last quarterly letter, I did preach caution. I also mentioned the threat of exogenous events and this strain of the coronavirus and the potential for this to turn into a pandemic certainly qualifies as an exogenous event. With that in mind a market meltdown does not guarantee a recession. Stock markets will have corrections all the time. I would call this a correction. What this does is bring us back to reality. I really felt the stock market had gotten well ahead of itself – rising 30% over last year with very little earnings growth as support. In the world of investing, there are some ratios that many investors track. One of these is a price-to-earnings ratio. This is simply the price of a share of stock (or index) divided by the earnings attributed to one share of stock (or one share of the index). This ratio tells you what investors are willing to pay for one year’s worth of earnings. If a company earned $1 per share over the past year and investors are willing to pay $10 for a share of the stock, this is a price-to-earnings or P/E ratio of 10. By itself, this tells you nothing but looked at over time, you can see trends. Looking at the S & P 500 Index, one of the more popular measures of the broad stock market, the P/E ratio on this index was 14.6 at the end of 2018 and 20.4 at the end of last year. This means investors were only willing to pay $14.60 for $1 worth of earnings at the end of 2018 but were willing to pay $20.40 for that same $1 worth of earnings at the end of 2019. In other words, investors were willing to take more risk – paying more for the same amount of earnings than the prior year.
What does all that mean and just exactly how does that relate to the coronavirus? Great question! Let me explain why this coronavirus is wreaking such havoc. Let’s start with the fact that the virus started in China. In response to the outbreak Chinese officials largely shut the country down. When it was first discovered it just happened to be during the Chinese New Year holiday. Everything shuts down in China for this celebration. In response to the virus, China extended their holiday during which all businesses were shut down. Even with this response the virus spread, and China shut down travel between all provinces and essentially put large sections of the country on lock down. As you probably know most U.S. companies have outsourced at least some part of their manufacturing to China. With these shutdowns in place, factories were closed effectively halting production. In addition, with the country effectively shut down, commerce ceased. No one was shopping except for essentials. The anticipation is China’s economy essentially had zero growth for this quarter.
The virus has since spread from China to every continent except Antarctica. We have learned that an individual can be contagious for up to 14 days before showing any symptoms. This has complicated responses to this virus. When new cases appear, the first response is to try to track the movements of the infected individual over the prior two weeks to see who else may be infected. This is prompting great fears of a coming pandemic and a worldwide response like China’s – shutting down everything until the virus is contained.
With China’s economy accounting for almost 20% of the global economy, any dramatic slowdown will have ripple effects. Further, the fact that supply chains for many U.S. companies were closed for several weeks will lead to lower sales of products here in the U.S. Apple, for instance, has already warned investors that due to “constrained” iPhone supply out of China and store closures in China, the company would not meet analysts’ expectations for their second quarter’s earnings. This scenario is playing out throughout the U.S. and the world. All of this is leading to the fear of the big “R” word – recession.
I do not think we are at the tipping point of a recession just yet. Much will depend upon how quickly the U.S. and the rest of the world can contain this virus. Right now, everyone is operating on fear. This fear is leading to people panicking and selling stocks and buying U.S. Treasury bonds (a very safe investment) and gold (another investment viewed as safe during times of crises). However, all the market losses are not solely due to coronavirus fears. These fears lead to selling but these sales drive prices down which trigger some automatic sell programs large advisors have in place. Add to that traders who try to take advantage of momentum by selling short – that is selling stocks they don’t own hoping to buy them back later at a lower price – and you have a recipe for panic selling.
What has not helped is that many companies are currently releasing their annual earnings reports for last year. In conjunction with these releases, companies tend to provide forecasts of their expectations for the coming quarter and year. Companies are no longer offering guidance for the year citing the uncertainty over the coronavirus. Without some idea of what a company may earn for the next year, it is hard for an investor to assess whether the stock is priced fairly or not. Returning to the P/E ratio I mentioned earlier, if I am willing to pay $18 for each $1 worth of earnings and I have a reasonable expectation a company may earn $5 per share next year, I would be willing to pay $90 for that stock. If the company tells me they now have no idea what they may earn, I am less willing to pay that $90 and may choose to pay a lot less - $75 or even $50 per share rather than the $90 I had been willing to pay.
What is going to stop all this selling? There are two things. One will be how quickly countries around the world manage to contain this virus. If new cases of the coronavirus hit a peak and start falling, this will be a sign that countries are starting to contain the virus. This seems to be happening in China currently, though the country is still not back to normal operations yet. However, other countries are only starting to see new cases pop up and these cases could spread to other countries. The other thing that will stop the selling is when prices have fallen far enough that investors feel like stocks are a bargain again and buying begins to outpace selling. I remain convinced that we are not on the verge of a recession – yet. I suspect the Federal Reserve, which sets interest rates for the U.S. economy, will cut their interest rate in mid-March in an attempt to forestall a recession. If countries can contain the virus reasonably quickly – within the next couple of weeks – our economy should bounce back from this current slowdown. If investors perceive this outcome, stock prices are likely to rebound though not necessarily straight back to recent highs.
If it takes countries longer to contain the virus this would be very detrimental to the global economy. There is already talk of cancelling the 2020 Olympics which are to be held in Tokyo this year. This would be just one step towards a global recession that would likely keep U.S. stock prices at depressed levels for a while. If new cases continue to pop up around the globe, especially in large numbers, over the next couple of months global growth would likely turn negative and this would likely tilt the U.S. towards a recession either later this year or early next year. I am paying close attention to developments not only with this coronavirus but also economically both here and abroad.
As long as this sell off is simply that – a market correction – I am not worried. Stock prices may not rebound immediately but they will recover from a correction. In a best-case scenario, we are probably talking weeks rather than months, but this is no guarantee. I have taken a few steps and will likely take a few more. I made several attempts to purchase put options – options that rise in value as stock prices fall. I was finally successful on Tuesday. By Thursday, I was closing out some of this position at a profit and closed out the last of these options early on Friday morning. We ended up with a decent profit across the board from these options transactions which helped offset some of the losses from the stock and equity mutual funds we own. We also have a reasonable allocation to bond funds which hold up well during volatile times like this. For several of you who are in retirement, I have added a couple of additional bond funds that lock in your estimated required distribution for the next couple of years. With a higher allocation to bonds that preserves capital, this buys us some time for markets to rebound. Lastly, much like everyone else, I am developing a “shopping list” of stocks that I would like to own if the price is right. Rest assured that I am keeping a very close eye on this situation.
The stock market roared this past year, gaining over 28% and serving up the best performance since 2013 when it gained over 29% for the year. There are a lot of things driving that performance. The recovery, now over ten years old, is one of the longest on record here in the U.S. Unemployment is at a multidecade low. Real wages are climbing, and consumer confidence remains solid. Corporate earnings continue to grow albeit at a slower pace than past years. Interest rates remain at historic lows and this trend looks to continue for the foreseeable future.
However, all is not necessarily smooth sailing. There are a few clouds on the horizon. If you will recall at this time last year the Federal Reserve changing their tone from “we need to keep raising rates” to “we will cut if needed”. This sparked a rally from the nearly 20% decline we saw through late December of 2018. The Fed did cut interest rates during the year, largely in response to economic weakness surrounding the ongoing trade war. In addition, we had a warning signal that flashed in late March. This was of course the notable “yield curve inversion” which occurred when the interest rate on a 2-year Treasury note was higher than the interest rate on a 10-year Treasury bond. Historically speaking, such inversions have been harbingers of recessions within the next 12 – 18 months.
And yet the market kept plugging along despite these warning signals and bad news. In August we had the trade war ramp up with an increase on existing tariffs and new tariffs implemented, though the administration did back off on the last round of threatened tariffs on most consumer goods until mid-December. This delay coupled with an additional interest rate cut forestalled the possibility of an imminent recession. And the market kept plugging along. In December we were given a “phase 1 trade deal” that really does not seem to have gone very far. It offers up some agricultural purchases and a few hints at intellectual property protection but is not nearly the sweeping reforms that were called nor needed when this trade war began. And the market continued to plug along.
Where are we at now? Are we in for more of the same in the coming year? Or will that recession that was forecast in March and many feel is overdue finally make an appearance? While earnings are expected to actually fall for the 2019 fourth quarter, most analysts expect earnings to rebound slightly in 2020 at low single digit growth rates. This leads to an expectation of stock returns in the high single digits for the coming year. As for me I can honestly say that I have no idea. At the risk of sounding like a broken record I am cautiously optimistic. Until we see more definitive signs of the economy breaking down, I have no reason to not be invested in stocks. But there are a few warning signs that I am paying attention to in the economy and the markets.
One warning sign for me is the lack of capital expenditures by companies. Capital expenditures refers to investments back into a company to promote future growth. This would be things like new plants or new equipment which would presage more growth down the road. One benefit that was supposed to come from the massive tax cuts corporations received at the end of 2017 was an increase in capital spending leading to higher growth in the economy. This was how the tax cuts would end up paying for themselves. The higher growth would lead to higher tax revenues. What we are seeing though is falling capital expenditures and only marginal earnings growth. This worries me. Companies shy away from making capital investments when they think there is a lot of uncertainty about the future growth prospects. When we had the ongoing trade war it could be argued there was a lot of uncertainty about future growth prospects. In theory though this has been resolved. Unless we see a significant pickup in spending in the next few months, I would argue there is still a lot of uncertainty surrounding growth and we are more likely to see a recession than an economic boom.
Another warning sign for me is also a Warren Buffett favorite. As you may know a key measure of how our economy is doing is the Gross Domestic Product or GDP. This measures the value of all goods and services we produce in the U.S. annually. The Wilshire 5000 Stock Index is the broadest index of stocks in the U.S. The St. Louis Federal Reserve bank tracks the total value of the stock market relative to the GDP of the U.S. The growth in the stock market should somewhat parallel the rise in GDP. Stock prices should rise as earnings for the underlying companies increase and earnings should increase if the total output from the U.S. economy is growing.
With data from the St. Louis Federal Reserve, we can track this ratio back to 1971. For most of the 1970’s though the mid-1990’s, this ratio was below the 80% level. This means the total stock market value was at or below 80% of the total value of the U.S. economy. In 2000, this ratio peaked at 134% only to fall back below 80% by 2003 in the recession. This ratio rose again through 2007, where it was over 100 again before plunging to 60 in early-2009 during the Great Recession. Why do I bring this up? Currently this ratio stands at an eye-popping level of 153% as of 2019 year-end. In other words the value of the stock market has increased much faster than the value of our total economy. Can this high valuation continue? Sure. However, I fear this trend is not sustainable.
There are three possible outcomes to this ratio. The first is that that economy heats up and “catches up” but this would not be good for stocks. If the economy started growing that rapidly it would likely bring with it much higher inflation which would lead the Federal Reserve to hike interest rates which would hurt stock prices. The second possible outcome is that stock prices plummet – as in a market correction. This has already been the result to two past peaks – 2000 and 2008 – and a third correction is not out of the question. The third scenario is some combination of the two – the economy grows faster while stock prices either stagnate or fall some but not tumultuously leading to a closing of this gap. Given these possible outcomes, you can see why I keep the ‘cautious’ in ‘cautiously optimistic’.
Another caution flag that is waving is coming from the Federal Reserve itself. While the Fed signaled that rate hikes were not imminent, there was a notable sound of concern that came out of the December Federal Reserve meeting. Several Federal Reserve members expressed concern that low interest rates might encourage “excessive risk taking” in the financial markets. I would argue this sentiment is long overdue. There are many who think we are in an “asset bubble” caused by the low interest rates for such a long period of time. The longer we maintain low interest rates, the more investors are pushed to invest in riskier assets for some sort of return. With all the uncertainty in the markets and an administration that governs by tweets and gut feeling raising interest rates would only choke off whatever small investments are being done currently.
Pile on top of all these issues an election year with a very uncertain Democratic field and you have a recipe for, at the very least, a fair amount of volatility. As I write this letter, we are in the midst of tense times with Iraq, Iran and the U.S. There are threats from both sides for strikes and retaliations. Typically speaking, this would lead to a sell-off in stocks, but the market keeps shrugging off the bad news and inching ever higher. Barring extraneous circumstances such as an outright war or a resumption of the trade war with China I do not see a recession on the horizon this year. I think the Federal Reserve will do everything they can to push that possibility off as long as possible. I think our economy will essentially continue to muddle along at a 1 - 2% growth rate.
This mix of good news and cautionary news means that we are not making any significant changes to portfolios. Last year, I indicated that I was reallocating client accounts, using a fair number of mutual funds when and where appropriate. I have not given up on the individual stocks as that has served us quite well. In fact, many of the stocks we have owned this year have done very well. For example as of year-end shipping company Seaspan Corp (ticker: SSW) has returned over 39% for us; Kenon Holdings Ltd (ticker: KEN), a holding company that holds interests in different businesses around the world, is up over 35% for us and homebuilder Meritage Homes (ticker: MTH) gave us a 45% return before we sold out of it completely in late-December.
In my last letter I mentioned that I am using options a bit more strategically now. I specifically referenced two different trades – one on Sanmina Corp. and one on Dick’s Sporting Goods. The Sanmina options trade finally expired on us in late-December. In the end, we earned just over $139 while only risking $2,900 in total. This doesn’t sound like a lot, but it means that we invested $2,900 and earned a 4.81% return on the money. That is not too shabby. As for our trade in Dick’s Sporting Goods that one did not quite work out the way I had planned. We had obligated ourselves to sell Dick’s at $40 only to see the stock pop dramatically from just under $40 in late-November to well over $46 per share in one day. We chose to buy back the option we had sold, which resulted in a loss, but we kept the stock which has continued to work its way towards the $50 per share mark. Perhaps at some point again we will sell more options against our position if the timing is right.
We are continuing with this theme of strategically using options on stocks we want to purchase. We recently entered a trade that obligates us to purchase shares of Discovery, Inc. (ticker: DISCA), the owners of the Discovery Channel, Animal Planet, Food Network and other cable channels, for $30 per share. We have taken in just over $80 in premium for this obligation which gives us a 2.7% return on the amount we are risking. We may end up earning a bit more if we extend our obligation. We have a similar strategy in Chipmos Technologies (ticker: IMOS), a maker of integrated circuits. This strategy has earned us a 3.94% return so far and, again, we may end up with more if we extend the timing of our obligation. We won’t always resort to options when we have stocks we want to purchase, but if the strategy seems appropriate and earns a reasonable rate of return it makes sense to go this route.
The mutual funds we own did reasonably well adding stability where we wanted it and growth where we needed it. For example, the Janus Henderson Multi-Sector Income fund (ticker: JMUTX) is a bond fund and would have a much more muted return than something like the Parnassus Mid Cap fund (ticker: PARMX) which we also own. During the fourth quarter, the Janus Henderson Multi-Sector fund gained 1.65% while the Parnassus Mid Cap fund grew 3.42% for the same period. However, the bond fund was not purchased for growth. Rather it pays a current dividend of 3.35% while the Parnassus fund which is designed for growth only pays a measly 0.50% in dividends but grew over 28% for the year. On the surface you may wonder why we didn’t just put everything into the Parnassus fund (or something similar) for the growth. The simple answer is there would be entirely too much risk in doing that. Rather than try to “time” the market it is far better to have a reasonable asset allocation that matches up with a client’s risk tolerance. The goal is to end up with a more stable return that exceeds your individual needs. Towards that end, we are continually looking for ways to improve the results for you without taking on additional risk.
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.
Alan R. Myers, CFA
President / Senior Portfolio Manager
Aerie Capital Management, LLC
This was a pretty volatile quarter we just went through. The broad stock market managed to eke out a new all-time high in late July before plunging 6% in just over a week. This plunge was driven by two things – a reaction to the Federal Reserve indicating that more future rate cuts were not a sure thing and a surprise increase in tariffs on Chinese goods.
Our current economy is still growing albeit very slowly at this point. We are already on a downward track as GDP growth – the measure of all output in our economy – has fallen from just over 3% in the first quarter to just over 2% in the second quarter and is expected to fall below 2% in the third quarter of the year. Mind you, a slowing economy does not necessarily mean “recession”, but when you throw additional, unplanned tariffs onto an economy that is already slowing you are setting the stage to make things worse rather than better for the economy. For there to be a recession we would need to go backwards with negative growth instead of just slowing growth.
All of this uncertainty has led to a market that is trapped in a range with a lot of volatility. Investors find themselves responding to tweets and headlines with no clear direction. Everyone is hoping for a trade resolution, and no one is seriously expecting a trade resolution. What is an investor to do then? If you hold stocks and stock mutual funds you risk losses should trade talks completely break down. If you don’t hold stocks and stock mutual fund you risk losing out on serious gains should we somehow end up with a trade deal. Neither prospect is satisfying. In the end, the best thing seems to be to ‘stay the course’.
Over the past quarter many of the stocks and mutual funds we have in client accounts did reasonably well. The Janus Henderson Balanced (ticker: JABAX) was up 2.60% for the quarter while the Janus Henderson Multi-Sector Income, the core bond fund we are using, was up 1.73% for the period. Among stocks – and we are still buying some individual stocks when the opportunity is right – Seaspan Corp (ticker: SSW) was up 9.70% for the quarter, Dick’s Sporting Goods (ticker: DKS) gained 18.32%, while our star holding Meritage Homes Corp. (ticker: MTH) gained a stellar 37.03% for the three months.
Not all came up roses, though. We did have several holdings that detracted from performance. The biggest losses for the quarter were from Compania Cervecerias Unidas (ticker: CCU), a Chilean brewer which fell about 21.5% before we sold at the end of August, while Warrior Met Coal (ticker: HCC) was off 17.87% when we sold it at the beginning of August. The worst performer was a specialty mutual fund that we hold in a few client accounts. The AdvisorShares Trust Pure Cannabis ETF (ticker: YOLO) fell 35.58% for the quarter. While the cannabis space would seem to be one that offers up a lot of promise we are probably much too early here. We are likely to exit this position sooner rather than later though it is one that we will keep on our radar.
Overall, I am moderately pleased with how the quarter turned out. I am still “tweaking” client account allocations and constantly looking to improve upon our holdings. Most of the changes that I have made or will make are largely adjustments to current holdings – adding to or subtracting from in order to adjust the amount of risk in a portfolio. While I am generally satisfied with our current lineup of funds and securities, I am always researching new ideas and funds. If I find a fund that offers better returns with similar levels of risk or similar returns with less risk, I am likely to make a change to our holdings.
Speaking of securities, in my last quarterly report I indicated that I was primarily moving to mutual funds across client accounts. This seemed to worry a few clients who were afraid I was going to sell every individual stock holding and move everything into mutual funds. Let me clarify this for you. If we currently have good, solid stock holdings there is no need to sell them. Second, while I am primarily moving to mutual funds this does not mean that I am giving up completely on individual securities. We have continued to do well with individual stock picks. There are two key reasons that I will add mutual funds to client accounts. One is to gain exposure to areas that are more difficult to access or research, and the other is to invest excess cash in order to earn a more reasonable return and hopefully improve long-term performance.
We did add new positions to client accounts this past quarter. We added a position in Manulife Financial Corp (ticker: MFC), and we wanted to add a position in tech company Sanmina Corp (ticker: SANM) but chose to use an option strategy instead. We obligated ourselves to purchase shares of Sanmina at $29 per share – about $2 below where the stock was priced when we entered our strategy. In exchange for taking on this obligation, we collected a premium. This premium paid us almost 1.5% on the amount of money we are risking over the 39 days until the option expires. This is a very nice return for such a short time period, so we win no matter what. We either buy the stock for a lower price or we keep this “interest” on the money we are risking. We also added a very special situation in a few smaller client accounts. We purchased shares of Parker Drilling (ticker: PKD) across a few accounts largely because the special situation limited us to buying fewer than 100 shares per account. The company is wanting to de-list from the stock exchange. In order to do so they are buying out shareholders who own less than 100 shares (what is known in the business as an “odd lot”) and will offer $30 per share to these shareholders. We paid around $21 per share and now we await the time to sell the shares back to the company and collect our profits.
As I write this letter, the U.S. and China have come to a trade agreement. From all indications, the agreement is relatively weak. China is agreeing to ramp up their purchases of agricultural products and the U.S. will not raise tariffs in October as planned. The biggest and most important elements that need to be addressed such intellectual property rights seem to be off the table for the moment. Markets have reacted positively to this news of a “trade deal”, but the key thing to keep in mind is that tariffs are still in place and no real progress has been made on the biggest trade issues. I remain a bit skeptical of the efficacy and success of this trade deal especially given that there is no timeline to end the current tariffs. There is only a tentative agreement not to increase tariffs in mid-October as originally planned. Further, there was no mention made of the tariffs that are scheduled to be implemented in December.
Given the weak trade deal and the continued weakness in sentiment I am still in the camp that says a recession is possible next year. It is certainly not guaranteed, and I do not wish for it, but I am prepared for it to happen. In the interim I am keeping clients invested in stocks even with the sometimes-increased volatility that can drive us all nuts. Should we continue to get partial trade deals that resolve some of the bigger issues, markets will continue higher. Should we instead inch towards a recession markets will fall. If that happens, I will adjust portfolios by cutting back on stock holdings and increasing bond investments. We can probably expect a lot of froth in the markets but little in the way of major gains or losses. This is completely frustrating, but it can create some opportunities. Much like the Sanmina Corp. trade I mentioned above, I will be strategically using options a bit more. The strategies, though, will lean to the conservative side. For example, I sold options against our shares of Dick’s Sporting Goods that obligated us to sell shares at a set price and we collected a premium for that. In fact, I have done this on four separate occasions, and we have collected about 3.68% of the price we originally paid for our DKS shares in premiums. Normally, I am not fond of these types of trades as it can limit the amount of profits we could potentially collect. However, I am convinced that we likely have more downside risk than upside potential, so these transactions have a better chance of being profitable for us. You are likely to see more transactions like this to boost cash and improve performance a bit.
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.
Alan R. Myers, CFA
President / Senior Portfolio Manager
Aerie Capital Management, LLC
Anyone that is paying even half-hearted attention to the news today will know that stock markets here fell. A lot. News agencies are likely to use words like “melted down” or “tumbled” and they won’t be far off the mark. The key question is likely to be “what the devil happened?!” After all, it was less than a week ago that the Federal Reserve cut their interest rates by 0.25% in an effort to spur investing and keep the growth story going. Should they have cut more? Why did we fall out of bed today?
There are several key reasons and they are all interrelated. We can boil them all down to one key idea – China trade. As you know, the Trump administration has been working towards a new Chinese trade deal seemingly from the first day. China has committed some bad acts – stealing our intellectual property by forcing any U.S. tech company that wants to do business in China to have a Chinese partner firm, for example. U.S. tech companies lined up to do this with eyes wide open just to gain access to their 1.4 billion consumers. This does not mean it was fair or right. It wasn’t and practices like that needed to be addressed.
We had apparently been having “productive” negotiations with China. A trade delegation returned from Shanghai on Tuesday and this was the report from the White House. Then on Thursday, President Trump tweeted that beginning on September 1, there will be a new round of 10% tariffs on the $300 billion of Chinese goods not already being taxed. The current tariffs that are in place were on what we call industrial and intermediate goods. Basically, the tariffs affected products used in production. This does not mean that we consumers did not pay these tariffs. It simply means they were more hidden. In fact, here is a chart from the U.S. Department of Labor that shows the effects of the tariffs to date. The blue line represents the change in prices for all goods that are being taxed while the dotted line represents the prices of all other goods. The shaded area represents the time the tariffs have been in place. As you can clearly see, shortly after the tariffs hit, the prices for all goods being taxed soared while the prices for all other goods has remained relatively stable. This directly contradicts the message coming out of this White House that there has been no noticeable affect of these tariffs and that China is absorbing the costs. Those are obviously false statements.
The next round of tariffs this administration wants to impose starting on September 1 will more directly impact consumers. These tariffs will hit companies like Nike and Apple, for example. It is estimated that over 60% of the products affected in this upcoming round of tariffs are consumer goods such as apparel and footwear, toys and cellphones. This means the consumer – you and me – are about to be hit more directly in our pocketbooks.
Now the tariffs are bad enough, but the bigger issue seems to be that this round of tariffs is signaling that a trade deal is all but off the table. You don’t have productive talks and then implement punishing tariffs. China, of course, has retaliated for this new slap in their face. The Chinese government has instructed their state-owned entities not to purchase any U.S. agricultural products. In 2017, we exported about $19.6 billion in agricultural products to China. I think it is safe to say that we will be lucky to ship a fraction of that this year. This has had a devastating impact on small American farmers. The USDA (Department of Agriculture) has tried to help these small farmers with $16 billion in aid. Basically, the USDA is paying out welfare to these farmers who have no markets for their crops. Just under a week ago, the White House said that based on those “constructive” talks, China was committed “to increase purchases of United States Agricultural exports.”
In addition to banning further purchases, China did something rather extraordinary today. China allowed the exchange rate for their currency to slip below a key and significant level. Without getting too far into the weeds, what this essentially does is make Chinese exports cheaper leading to other countries buying Chinese goods that we do not or cannot purchase. President Trump is very likely to hike the tariffs to 25% to retaliate for the retaliation. We are essentially in an all-out trade war now, and there does not seem to be any hope for a deal on the horizon. At this point I believe President Trump was correct when he said the Chinese were going to wait for the elections in the hopes of getting a new administration to negotiate with.
What is the outlook going forward? There are several things that I think will happen. First is that with higher costs on goods we import from China – and we will keep importing these goods from China because we cannot shift manufacturing overnight to another country or back to the U.S. – this will likely result in lower consumer spending. Second is that we are very likely to get more Fed interest rate cuts, but these won’t do anything to help the situation. Why? The biggest issue right now domestically is a lack of investment by businesses. By “investment” I don’t mean buying stocks and bonds but investing in new plants and equipment. Business spending has essentially ground to a halt. The Trump administration claimed the tax cuts would spur more business spending. Tax policy has never influenced business investment. Businesses make investment decisions based on how much of a return they can earn. Interest rates influence this far more than tax policy. And, while lower interest rates can entice businesses to invest more in plants and equipment, what businesses really want is clarity. With the world a very uncertain place right now and the trade war heating up instead of winding down businesses are looking for ways to protect themselves, not take chances on new ventures.
Third, with decreased business investment, this is likely to lead to stagnant earnings at best and more likely lower earnings down the road. This is likely to result in something called “P/E compression”. Basically, investors are willing to pay a certain amount for a year’s worth of a stock’s earnings. For example, if a company earns $2 per share for the year and the stock sells for $20 per share, this is P/E ratio of 10. Typically speaking, the broad market will sell for a P/E ratio around 15 – 18 times earnings per share. That is, if the earnings for the market is $100, then a P/E ratio of 18 would imply a price of 1,800 for the S&P 500 Index. As of the end of July, based on what companies in the index had earned for the twelve months, the P/E ratio on the index was about 21 times earnings. This is on the high end of things but not outrageous. However, if investors decide that, given weaker global economies and slower growth, they were not willing to pay more than 15 times earnings, this would lead to the S&P 500 Index falling to around 2130, assuming earnings don’t change. This would be a loss of over 28% for the index! I do not expect this dramatic of a correction, and this type of a correction is not likely to happen suddenly, but I do expect investors to pay less for earnings than they have been paying recently.
Fourth, I think the odds of a recession have dramatically increased. We are not there yet, but we certainly seem to be pointed in that direction. If that is the case we will want to scale back on stocks going in to the recession and load up on bonds in anticipation of the interest rate cuts. When interest rates fall, bond prices tend to rise driving up the value of bonds you own. Anticipating and being ready to act will help steer us through this mess.
What did we do in the face of this turmoil today? Basically, nothing. Actually, that is not quite true. We did make one change in portfolios. We have been using the PIMCO Income fund as our “go to” bond fund. This fund has a very admirable track record but, frankly I have been worried about it in client accounts. This fund has taken some risks to achieve their returns and that has worried me. So today we moved most of our holdings in the PIMCO Income fund over to the Janus Henderson Multi-Sector Income fund (JMUTX). This fund also has an admirable track record, lower fees, is smaller and more nimble and has less risk than the PIMCO fund.
In addition to this change I have been investigating an idea to take advantage of the trade war. Businesses want clarity and they want to outsource manufacturing to cheaper labor. China had provided that but that is not an option currently. Businesses are starting to look at other countries in the region as a substitute. My suspicion is that Vietnam will be a beneficiary of this trade war, so I am likely to add an investment in a fund that invests in the Vietnamese market. I will probably dip our toe in the water initially and add to it over time if it begins to pan out. Additionally, I will be gradually shifting some funds from stocks to bonds if we continue along the current trajectory. There will be a time when we will want to start buying stocks again, but this is not necessarily that time.
As always, if you have any questions for me or need anything, please feel free to call me!
Alan R. Myers, CFA
President / Senior Portfolio Manager
Aerie Capital Management, LLC
We have arrived at the end of another quarter, and it has been one of more change. As you know, we have been going through a “re-boot” with a new logo and a new web site. Those were easy and cosmetic changes. The changes being made now are more fundamental to the business. You may have noticed a fair amount of trading throughout the quarter. We were gradually reallocating client accounts into select mutual funds.
This goes to the heart of one of the key changes I have implemented. In the past I have attempted to pick good stocks for client accounts. I would try to find stocks that were “mispriced” – selling for less than a calculated intrinsic value. However, times have changed. This worked reasonably well for several years. It took a lot of work, but that was the fun part for me. It was often a labor of love and when we bought into a stock that then did very well, that was gratifying.
Information travels much faster now. When I was buying individual stocks, my starting point was to look at key factors that had been shown to lead to higher investment returns based on academic research. This has now evolved into a major business for large institutional investors. These firms have created funds that invest based on these “factors”. With billions of dollars pouring into these funds, it is far more challenging for old hands like me. If you Google search “factor investing” you will get 102 million search results! These firms have computers that can scan the investing universe in seconds and find stocks that meet their criteria virtually in an instant. Worse, because these funds are targeting the same factors that I was looking at the end result is that any advantage we had is arbitraged away. A decade ago, there were not a lot of people investing the way I was. Now there are billions of dollars in mutual funds and exchange-traded funds using the same factors I do and all at the same time. This results in a loss of an investment advantage and reduced returns. Therefore, I am moving my clients more and more to mutual funds. This is what you have been seeing in your accounts – the move to a few key mutual funds.
This does not mean that I will stop looking for individual stocks based on the factors that I think make sense. However, I am leaving the purchase of these individual stocks to larger accounts and limiting the amount I invest in any one name to limit the risk. These larger accounts will also have a large mutual fund component as well as a “core” around which to build with the individual stocks. Everyone is benefitting from this shift to mutual funds.
I can tell you the move to mutual funds has not come without a few growing pains. The search for the right funds to use in client accounts has been very challenging. There are a number of factors that I consider before settling on an appropriate fund. While performance is certainly one key factor – we definitely want funds that will provide a good long-term growth rate for us – I am looking at far more than just the best 1-year or 10-year return. I am looking at consistent performance over time. Ideally, we want funds that consistently perform in the top 25% of their peer group. However, there is far more to it than “how much did it grow?”. Another key factor is what we in this business refer to as “upside versus downside capture”. This sounds complicated but is easy to understand. I am looking at how well a fund performed when the market went up and how it performed during down markets. If a mutual fund grew faster than the markets during up times this may be good but if it lost a lot more during downturns that could be very troubling. We don’t want a fund that grows 5% more than the overall market during good times but loses 15% more during bear markets. This digs a deeper hole to climb out of for the managers. I am looking for funds that control risk – that is, funds that lose less during down markets. We can win by not losing.
We have added several mutual funds across client accounts. Chief among the relatively newly added funds is the Janus Henderson Balanced fund (ticker: JABAX). This fund and the T. Rowe Price Capital Appreciation (ticker: PRWCX) fund – which is currently closed to any new investors – are the “core” funds in client accounts. Both funds will hold 50 – 70% of the fund in stocks with the balance in bonds. The manager will decide when to tilt more toward stocks and when to cut back and tilt toward bonds. Both have a long history of being relatively conservative in their investment style while not sacrificing returns. One of these funds will generally comprise anywhere from 25% up to 50% of a client account depending upon the situation, the risk tolerance and risk capacity of the client.
In addition to these two core funds, we are supplementing them with the T. Rowe Price Small Cap Value (ticker: PRSVX) fund for exposure to small company stocks and a blend of the Parnassus Mid-Cap (ticker: PARMX) fund and the BlackRock Mid-Cap Growth (ticker: BMGAX) fund for exposure to mid-sized company stocks. Both small company stocks and mid-sized company stocks generally have greater growth potential but may also come with additional risks. To offset some of the risk of these additional funds, we are using the PIMCO Income fund (ticker: PONAX) which invests in bonds.
So now that we are using mutual funds, what is my role? My key task now is asset allocation. That is, trying to find that blend between stocks and bonds that will serve to offer the best return that we want or need for your account with the least amount of risk. It is also my role to monitor what is happening in the economy and adjust portfolios as needed. For example, currently there is much talk of a coming recession. The big worry is the “inverted yield curve”. I wrote about this recently but let me touch briefly on it again. An inverted yield curve happens when you can earn more interest on a short-term loan (bond) than on a long-term loan (bond). Historically, whenever there is a yield curve inversion, a recession will typically occur within the next twelve to eighteen months. With the timing of the recent yield curve inversion, this would indicate a possible recession sometime between the end of this year and the middle of next year if it were to occur.
As I have mentioned in past letters the Federal Reserve is largely responsible for setting interest rates within the economy. They have a couple of tools to do this, but chief among them is what is known as the Fed funds rate – the interest rate banks are charged to borrow money overnight. The Fed raised this interest rate back in December setting it effectively at a 2.38% rate. In January, the Federal Reserve turned “dovish” – that is, they indicated they were less inclined to keep raising interest rates given the on-going trade wars and signs of slowing economies around the world.
Currently, markets are predicting the Fed will cut interest rates. That would be a very odd thing to do. The economy is doing reasonably well. Job growth continues at a moderate pace, unemployment is near historically low levels and inflation is virtually non-existent according to the measures the Federal Reserve uses. Typically speaking, interest rates are raised when the economy is very strong. The key reason for raising interest rates in that type of environment is to keep inflation from being a problem. Conversely, the Fed will lower interest rates when the economy is slowing, and things are turning bad. To cut interest rates now – during a strong economy – is somewhere between silly and dangerous. If the Fed were to cut interest rates by the typical 0.25%, this little if any effect. If they cut by more than that or had several rate cuts the market might infer that the economy is much weaker than it appears, which could actually spark a recession. Besides, if the Fed cuts rates now – in an economy that is still reasonably strong – when we do move into a recession there will be less room to cut interest rates to spur growth which could exacerbate any recession. I think Fed Chair Powell knows this and would like to preserve the interest rate tool for when it is really needed.
With that said, should our economy slip into a recession I will be reallocating portfolios. Currently, almost everyone’s account holds more stocks than bonds. There are two key reasons for this. The first is that bonds – those with the safest credit rating – generally do not pay a very high interest rate. A very safe corporate bond would only pay about 3% interest per year. Meanwhile, you can get a dividend yield of 2.4% on high quality stocks and the potential to see your money grow 8 – 10% per year. The bond is only going to give you the 3% interest and the original investment back. The second key reason that I will reallocate to bonds should our economy start to slip into a recession is the Federal Reserve would cut interest rates to reignite growth. When interest rates fall bond prices will rise. This makes holding bonds and bond mutual funds a nice hedge to stocks in tough times. If a recession seems imminent, accounts will lean more heavily on bonds than stocks.
As you can see, this investing thing is not simply “buy an index fund and forget about it”. There is a lot more involved here. While I feel like I have a great fund lineup for clients, I am always keeping my eye out for funds that may be a better fit – either because they offer a slightly better return with the same level of risk or they offer comparable returns with far less risk. In addition, I am remaining focused on how things are going in the economy, so I can adjust client accounts in order to continue meeting our investing goals.
Let me emphasize that it is my job to assist you. If you have any questions or would like to discuss anything, please feel free to give me a call! As always, I am honored and humbled that you have given me the opportunity to serve as your financial advisor.
Alan R. Myers, CFA
President / Senior Portfolio Manager
Aerie Capital Management, LLC
The markets just had their best quarter in a decade. Literally. Given how volatile they were in the fourth quarter of last year and how far down they had fallen (almost 20% in less than three months) it was no surprise to see a rebound. What was surprising was the strength of the rebound. There are many – me included – that think we have come too far too fast. It would not surprise me to see stocks sell off at some point though not likely back to the lows of December and not without a catalyst.
There are many that think we have a catalyst for a severe drop right around the corner. That catalyst’s name is “Recession”. There is a lot of talk about a coming recession. There are several factors that have led to this interest and worry. First, corporate earnings growth is slowing down. Add to that economic data that paints a worrisome if mixed picture – slow retail sales in December, a dramatic falloff in jobs in February and slowing global economies most notably in Germany and China – and you have the seeds of recession anxiety.
The one sign that has set everyone on edge is the dreaded inverted yield curve. I wrote about this in a recent blog (www.aeriecapitalmgmt.com/blog) but will touch on it briefly here again. The yield curve is a measure of what you get paid for buying a bond and holding it until it matures. The longer the time until the bond matures – that is, the longer you are tying up your money – the more interest you will demand. This makes sense. If you think about CDs at your bank you earn more interest in a 2-year CD than you do a 6-month CD for this same reason. The yield curve is looking specifically at Treasury bonds issued by the U.S. Government. When the yield (interest you earn) on a shorter-dated bond is higher than that of a longer-dated bond, we have an inverted yield curve. This first happened back in December when the interest rate on a 2-year Treasury note was higher than that on a 5-year Treasury note. Then, on March 22, the interest rate on a 3-month Treasury bill spiked above the interest rate on a 10-year Treasury bond. Historically speaking the last seven recessions were preceded by a yield curve inversion. On average a recession followed a yield curve inversion by about 11 months.
Pile on top of this evidence the fact that the economic expansion is now approaching its 10-year anniversary which seems, to many people, to be long in the tooth and everyone is afraid a recession is imminent. But what exactly is a recession, and why should we worry? The official arbiter of recessions in the U.S. is the National Bureau of Economic Research (NBER). This is a private, nonprofit, nonpartisan organization dedicated to conducting economic research. The NBER defines a recession as “a significant decline in activity spread across the economy, lasting more than a few months.” It is measured by data tied to “industrial production, employment, real income and wholesale-retail sales.”
The key here is that the measure is not tied to just one or two sectors. Just because retail sales fall for two quarters does not mean we have a recession. And it takes some time for the NBER to call a recession. It took them nearly a year to confirm the last recession (2008) and by the time they confirmed it, it was a forgone conclusion.
Why do we care about recessions? For most Americans job insecurity increases, layoffs rise, company earnings fall, retail and corporate sales slow and stock prices fall. Bear markets – a 20% or greater decline in the S&P 500 Index – are typically tied to recessions. In the last recession, the market fell almost 57% at its lowest point. It certainly pays to be both aware of and wary of recessions. At the very least one can prepare by reallocating your portfolio.
The question becomes – since we have had an inverted yield curve and we are getting some slightly disturbing economic news, should we be worried about a coming recession and should we reallocate our accounts or sell everything and go to cash? The short answer is “no” to both. How do I know this? The truth is I don’t know that we aren’t heading for a recession. I am pretty confidant we are not heading for a recession in the very near future.
The Conference Board, a nonprofit group of 1,200 businesses and organizations from around the world, compiles what is called the Leading Economic Index© or LEI. There are ten components to the LEI and they are leading predictors of economic activity. They run the gamut from the jobs numbers to the S&P 500 Index, the yield curve (looking for an inversion) to orders for “durable goods” (think ovens and refrigerators) to consumer expectations. Each month the Conference Board plugs the numbers into a formula, and they report on the LEI every month. All ten of these indicators tend to foreshadow things to come. For example, if businesses are cutting back on orders this could foreshadow a slowdown in sales which would lead to potential layoffs and rising unemployment numbers and waning consumer confidence and so on. Why ten of them? One or two might send out false signals. With ten, it’s more likely to indicate a true trend. Does this mean every time the LEI falls we are heading into a recession? Based on past history the lead time given by the LEI has ranged from 7-20 months before a recession occurs. However, there have been times when the LEI has given false recessionary signals including in the mid-1960’s, the mid-1990’s, the late 1990’s and even during the recent expansion we are experiencing.
According to the Conference Board, the LEI has been essentially flat since October. It has correctly signaled the U.S. economy is slowing down but it has not signaled a recession yet. In fact, the Conference Board recently issued a report that is cautiously optimistic on continued growth for the U.S. economy. There have been some shifts that may forestall a recession. The Federal Reserve has made an about face from indicating they wanted to raise interest rates at least twice this year to pushing off even one interest rate hike until next year, if at all. Add to this the fact that recessions are usually preceded by major economic imbalances – a stock market bubble as in 2000 or a housing bubble like we had before the 2008 recession or the Federal Reserve sharply raising interest rates to tame inflation.
None of those conditions exist – currently. I say “currently” because this could change in an instant. There are a few things I am watching cautiously. Chief among them is a China-U.S. trade deal. Everything points to both sides wanting a trade deal, but with China’s economy seemingly turning upwards again, I fear they may not need a deal as much as we need a deal. Further, I worry the current administration will see fit to crank up the tariff war if all their conditions are not met in these trade negotiations. I worry this administration will follow through on closing the Mexican border or will implement high tariffs on autos and parts coming in from Mexico. Any of these types of scenarios could tilt us over into a recession. On the flip side if we do get a trade deal and the tariffs come down nothing says we cannot continue this expansion for any number of years. In fact, Australia has gone for just over 25 years without a recession, beating out the Netherlands for the country with the longest post-war expansion. Can the U.S. expansion last 25 years? That is certainly possible. One thing some pundits like to point out is that it is different this time. We seem to be in a period of very low interest rates coupled with little or no inflation. However, I always worry when someone says “it’s different this time” as that usually means that it is not. The bottom line is that I am cautiously optimistic for continued growth.
How are we navigating these waters? Currently we still have a fair amount of cash across client accounts. I did put a little to work when we had the second yield curve inversion and the markets fell around 2% for the day. I fully intend to take advantage of more opportunities like that – adding to core positions when markets fall. Should it look like we are heading into a recession, you can expect me to add more bonds to client accounts. Typically speaking, when recessions hit the Federal Reserve will cut interest rates to entice people and companies to borrow money to invest in new plant and equipment to spur economic growth. As a side effect of this when interest rates fall, bond prices will rise. For example, a 30-year Treasury bond originally issued with a face value of $1,000 back in November 2007 and paying 5% interest, could be sold today for $1,333 on the open market. Why is this? It is because interest rates are about half of what they were at the time the bond was first sold. Given this tendency I would add more bonds and bond funds to client accounts to take advantage of this fact.
In the interim I am sticking with what I know. I have a model that is working well. I am looking for value stocks with momentum behind them, so we can see continued growth in price. When the model gives me stocks to buy I will add them to client accounts. Already this quarter, this model has added two Brazilian stocks in oil giant PetroBras (ticker: PBR) and phone company Telefonica Brasil (ticker: VIV). We also added an oil services company ProPetro Holdings (ticker: PUMP) and a coal company that supplies coal to the steel industry, Warrior Met Coal (ticker: HCC).
In addition to my model I am always looking for special opportunities. We recently added semiconductor company Mellanox Technologies (ticker: MLNX) to several client accounts. Mellanox is being bought by NVIDIA Corp for $125 in cash. Given the price we paid we will earn a reasonably sure 5.7%, which may not seem like a lot. However, if the deal closes by the end of October as we expect, we will have over 9% on an annualized basis.
As of the end of March (I run my screen monthly) there were no new stocks to add to client portfolios. This may indicate that we are at or near fair value on most stocks. If we get any pullbacks, I would anticipate having more stock names hit my list. Until then I am not going to force anything. We are not required to buy every month just because we have cash. As Warren Buffett once wrote, we can afford to sit and wait for that “fat pitch” to come to us. In other words, we can wait for great investments to come along.
We do have a game plan in place for whatever is to come. If the expansion continues, we are going to continue to do what we do – finding great companies trading at reasonable valuations that have the potential to show continued price appreciation. We will also seek out those special opportunities as they come along to enhance our returns. If we do head into a recession then it is bond, bonds and more bonds. But there is no need to panic and rush into bonds or even to sell out and go to all cash just yet. The U.S. economy is still on pretty good footing even if things are slowing down a bit. As long as Congress and the current administration can stay out of the way of business this expansion could easily become the longest on record for the U.S. I will not attempt to predict whether we can make it another 15 or more years to vie for the longest expansion record.
Let me emphasize that it is my job to assist you. If you have any questions or would like to discuss anything, please feel free to give me a call! As always, I am honored and humbled that you have given me the opportunity to serve as your financial advisor.
Alan R. Myers, CFA
President / Senior Portfolio Manager
Aerie Capital Management, LLC
There was a lot of talk Friday on business news channels about the “yield curve inverting”. This is not the first time this has happened recently, but it did seem to carry more weight this time around. The stock market fell around 2% based on this event. What exactly is a yield curve inversion and what implications does it have for us? Before getting into that let me back up half a step and explain a couple of concepts.
First, I want to briefly explain how bonds work. Think of a bond as an interest-only loan. If you buy a bond you are loaning money to a company (i.e. Tesla, IBM or ExxonMobile) or municipality or government. In exchange for this loan, the entity agrees to pay you a set interest rate for the term of the loan. At the end of this loan the entity will pay you the last interest payment and repay the original loan amount. This repayment date is known as the maturity date.
Typically speaking the longer the term of the loan, the higher the interest rate paid. This makes sense. If you are agreeing to tie up your money for ten years you would demand a higher return than if you were only loaning it out for two years. This is an important concept to understand when we start talking about the yield curve. The yield curve is simply a graph of the interest rate you would expect to receive relative to how long until the bond matures. The shorter the time to maturity the lower the interest rate you would collect and the longer the time to maturity, the greater the interest rate.
More specifically, the yield curve investors are concerned with is that of Treasury securities – bonds of the U.S. Government. We would start with a 3-month T-bill and move out in maturities through the 2-year note, a 5-year note, a 10-year bond and finally a 30-year bond. Suppose a 3-month bond paid you 2% in interest while a 1-year bond paid 2.75%, a 2-year bond paid 3.35%, a 5-year bond paid 4% and so forth. The normal yield curve would be a sort of gradual upslope as in this picture from Investopedia.com. (https://www.investopedia.com/terms/y/yieldcurve.asp).
Again, this is normally what we would expect for investing in a bond. We would receive a bit more interest for tying up our money for each additional year. When things are dramatically different from this situation, we need to pay attention. That is where we currently find ourselves.
In early December we had the first hint of things going wrong. On December 4 the interest rate on a 2-year Treasury note ended the day higher than the interest rate on a 5-year Treasury note. In other words you were paid more to invest for only two years than if you invested for five years. This is not a normal situation. The stock market fell 1% for the day. In fact, it continued to fall up through Christmas Eve where it bottomed out.
In early-January Fed Chairman Jay Powell gave a presentation to a roomful of economists. He said the Fed was essentially done with raising interest rates and would be paying much closer attention to the markets (meaning the stock market, of course). This calmed markets and a rally started. But should we still be worried? Was the December inversion a blip on the radar? Should we be worried and, if so, about what?
It turns out that a yield curve inversion does offer up something we should be concerned about. The yield curve inversion is a great predictor of a recession. In fact, the last seven recessions were preceded by yield curve inversions. If we really are facing a recession, why hasn’t the market melted down yet and what caused the Friday panic?
March has given us some rather troubling economic data. One key economic report people pay attention to is the jobs report – the report of the number of new jobs that were created in the economy for the prior month. In early-March we received the report for February. Economists had been expecting 190,000 new jobs but the report came in at only 20,000 new jobs for the month. This is also well below the average of over 220,000 new jobs added each month for 2018. In addition, there have been reports from around the globe of slowing economies. Manufacturing in Germany hit a multi-year low last week. We learned that retail sales in December were far lower than anyone expected.
The Federal Reserve met this past week to discuss whether to raise interest rates again. They had a two-day meeting, releasing the results on Wednesday. As was widely expected interest rates were left unchanged. In fact, they stated they did not expect to raise interest rates at all this year and perhaps only once next year. This received the lion’s share of the press.
However, what disturbed me most – and was not very widely discussed in the financial press – was what the Fed’s outlook was for the U.S. economy. In announcing their rate decision, the Fed accompanied it with commentary on what went into the decision. The key takeaway for me was their comment about lowering the expectation for growth in the U.S. economy for this year. The Fed cut their expectation for economic growth from 2.3% back to 2.1% for this year. Let me be clear. The fact that our economy may slow from 3.4% growth last year to just over 2% this year is not a recession. It is a disturbing trend, though. If the inverted yield curve prediction is correct we are likely to enter a recession early next year.
Believe it or not, as troubling as the yield curve inversion was in December, that is not what led the markets to fall on Friday. When the interest rate on the 3-month Treasury bill rose above the interest rate on a 10-year Treasury bond on Friday investors were ready to see the worst. This was almost confirmation of what happened back in December. Investors greeted this news by selling in droves. The broad stock market fell about 2% for the day. The small cap index Russell 2000 fell over 3.5% for the day. Whether this continues into next week or not is anybody’s guess. Again, I will reiterate that a recession is not right around the corner. However, this knowledge of what could happen and when gives us the advantage of being able to re-position accounts for a potential recession. For example, if our economy does turn negative, the Fed is more likely to cut interest rates next year rather than raising them. This would bode well for bonds giving us one place we might look for safety.
Does this potential meltdown frighten me? Not at all. I have been expecting this. In fact, I would welcome a pull back in the broad market. After bottoming out on Christmas Eve the markets rallied over 21% through last Thursday. This was, in my opinion, too far too fast. If markets do fall it would give me the chance to put some of the cash in client accounts to work. In fact, I did a little bit of that on Friday. I am ready to continue this trend on Monday, but I also have two or three other ideas in mind as well. When markets move in extremes like this there are pockets of inefficiency. Stocks get mispriced and offer up tempting investment opportunities. I have a list ready of ideas that I would love to pounce on if given the chance.
As always, I welcome your questions or feedback!