Client Letter 1Q 2020
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
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