Client Letter 2Q 2021
The operating watchword for this past quarter was “inflation”. We were preparing to hear from the Federal government on their measure of inflation and the only question was “how high”. Prices have been steadily increasing as we slowly return to a more normal post-pandemic economy. Everyone knew inflation for the first quarter of this year would be high. After all, we were comparing current prices to the first quarter of last year when the economy was shut down. We were comparing apples to oranges.
The inflation rate for April came in a 4.2% and then rose to 5.0% for May, significantly above the 2.6% rate for March and the 1.2% average for all of 2020. When the quarter started, the interest rate on a 10-year U.S. Treasury bond was 1.746% which was significantly above its pandemic low of a 0.538% interest rate. This interest rate reflected investors’ fears that inflation was imminent, and the Fed might raise interest rates to combat this problem. The key question argued between economists and investors was whether this high inflation rate was real and sustainable or, in the words of most economists “transitory”. Federal Reserve Chairman Jay Powell is in the latter camp, which has led him to not react to these high inflation numbers. Let me explain.
During a recession, no one is spending any money. There is no incentive to spend now as prices are likely to fall tomorrow making the goods or services you want cheaper. To spur spending, the Federal Reserve would lower interest rates. The chief idea would be for businesses to see a low enough interest rate to incentivize them to borrow money to buy land, build new plants, buy new equipment, and hire more workers to “jump start” the economy. This has been one of the main tactics during the past two recessions – the 2008 housing bubble and the recent pandemic economic shutdown. The Federal Reserve lowered interest rates to basically zero on the shortest-term loans to drive investment. It has not worked exactly as planned, but that is another story.
On the flip side, when there is inflation in an economy, prices are rising, often rapidly. When inflation exists, the incentive is to spend money now before it loses its value. Inflation also drives people to borrow money now to buy big ticket items now (houses, cars, appliances) before their prices are out of reach. If things get out of control, we have what is called hyperinflation. The poster child for this phenomenon was Germany post World War I. There are several stories out of this time about how quickly prices could change, even over lunch. There is the story of a student at Freiburg University who ordered a cup of coffee at a café. The price on the menu was 5,000 Marks. He had two cups. When the bill came, it was for 14,000 Marks. He was told that if he wanted to save money and have two cups of coffee, he should have ordered them at the same time (from Paper Money by “Adam Smith”). To stop inflation, the Federal Reserve would raise interest rates charged to banks, forcing banks to raise interest rates they charge their borrowers. If interest rates reach a high enough point, it will “choke off” this borrowing and sanity will be restored to the economy.
For anyone that lived through the high inflation of the late-1970’s and early 1980’s, the fear of high inflation is very real. Let me be clear here. I do not expect a return to those inflationary rates. That was largely caused by the oil supply shock which dramatically and unexpectedly increased the price of oil very quickly. This sent shockwaves through our economy which was largely built on using oil for everything from gas-guzzling cars to plastics. And, to the point that I made earlier, this bout of inflation was finally reigned in when Fed Chairman Paul Volker dramatically raised interest rates and within three years brought inflation from over 13.5% down to around 3% annually.
Circling back to the question at hand, are we facing increasing inflation or is it just transitory as many economists and the Federal Reserve seem to think. Frankly, I believe that it is transitory. We are already seeing the prices of many commodities that had soared in value coming back down to earth again. We need only look to the futures markets to see this. For example, lumber traded as low as $282.10 per 1,000 board feet in early-April 2020 during the pandemic, climbed as high as $1,733.50 in mid-May this year before falling back to $737.40 at the end of June. We have seen similar moves in corn, wheat, copper, and most other commodities as well. All these commodities are well off their recent highs set in mid-May. If this is truly indicative of transitory inflation, the Fed is correct not to raise interest rates now as that could potentially choke off the recovery from the pandemic. In fact, the Federal Reserve, in their most recent meeting, indicated they would most likely not be raising interest rates until 2023. I am cautious on this expectation and would not be surprised to see a late-2022 rate hike. I believe data may force them to move sooner than they want but, regardless, we still have at least a year of continued low interest rates fueling continued money flows into the stock market. The key reason for this, as I have been saying for a while, is that this is a TINA world – as in ‘there is no alternative’ to stocks if you want to earn any return at all.
All this fascination with inflation led to an interesting rotation in stocks for the quarter. Many stocks that have been beneficiaries of the re-opening of the economy such as the airlines fell the hardest. Stocks that gained for the quarter were heavily tilted to oil companies and industrial names, both of which tend to benefit from inflationary pressures. I suspect the staying power of these oil and basic industrial stocks is as transitory as commodity prices have been. Trying to time the markets by picking and choosing the ‘hot’ sector is a fool’s errand and something we avoid. I prefer to find stocks that meet strict criteria and stick with them provided they continue to meet our standards for growth, quality, and potential long-term returns.
We did a lot more trading this quarter than we normally like to do but most trades worked out in our favor. During the quarter, we sold out of Beazer Homes USA (ticker: BZH) for a 23.73% gain, eliminated Cardinal Health, Inc. (ticker: CAH) with a small 4.17% gain, sold sporting goods retailer Hibbett, Inc. (ticker: HIBB) for a 53% gain, exited boating retailer MarineMax, Inc. (ticker: HZO) with a 60% profit and closed our position in construction firm Primoris Services Corp (ticker: PRIM) with a small 13% loss. We sold either because the quality of the company had slipped in their recent earnings report, they were trading well above our estimate of a fair price, or their growth prospects were falling.
On the flip side, we put some profits back to work, adding to our existing holdings in Atlas Air Worldwide (ticker: AAWW) as well as several new positions. These new holdings include paper products company Clearwater Paper Corp. (ticker: CLW), two home décor stores, At Home Group (ticker: HOME) and Williams-Sonoma Inc. (ticker: WSM), apparel retailer Citi Trends, Inc. (ticker: CTRN) and RV dealer Camping World Holdings, Inc. (ticker: CWH).
We also recognized that we had too much idle cash just sitting around collecting dust in many accounts. Rather than let that continue to sit idle earning 0.01%, we bought an exchange-trade fund, the SPDR Bloomberg Barclays Investment Grade Floating Rate ETF (ticker: FLRN) that invests in short-term corporate bonds that have adjustable interest rates. This will be beneficial when interest rates do finally start going up as the interest rates paid on these bonds will also increase resulting in higher dividend yields on this fund. In the interim, the fund is paying a dividend of 0.21% on a “cash-like” investment. It is important to note that this is not a guaranteed investment, and the value can and will change. Typically speaking, the price of this fund will remain reasonably stable over the short-term. This is not an investment in which we are looking for large capital gains. We were looking for an investment that is reasonably safe, liquid, and earning something more than leaving the money in cash. This fund fit that bill well.
One last point on the cash management front. One additional tool we have been using up until recently has been an options strategy called a “bull put spread” in client accounts. This has often offered us a 10 – 11% return on the amount we were risking over the course of a month. Basically, we were acting as an insurance company for people who thought the market might fall. They might purchase insurance on their portfolios in the form of put options that would pay them cash if the market fell below a certain level. We took the other side of that trade but to offset our risk, we would purchase insurance ourselves just a little bit lower in value. For example, with the S&P 500 Index trading around 4,369, we might sell an option that obligates us to pay the holder if the index fell in value to 3,995 at expiration. To offset this risk, we would turn around and purchase an option that would pay us if the index fell to 3,990, limiting our risk to the $5 difference between these two values or $500 in total. To further mitigate risk, I typically limit the number of option contracts to only 1% of any individual’s account size, though some clients can afford to take a bit more risk. This ensures that, even in the event of a market blowup, we won’t lose more than we can easily recover in a short time. This strategy typically added over 2% or more to account performance over the first half of this year in those account where we have actively traded. The key reason we have stopped doing this for now is that, with the complacency that seems to have settled over the markets, we cannot get enough premium to make this strategy worthwhile for now. I am sure this will change again in time, and we will return to this strategy.
As always, we truly appreciate the trust you have placed in us, and the opportunity you have given us to manage a portion of your assets. If you have any questions or need to discuss any issues, please feel free to give us a call.
Alan R. Myers, CFA
President / Senior Portfolio Manager
Aerie Capital Management, LLC
10/18/2022 02:35:39 pm
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