Client Letter 4Q2020
This year has certainly been one for the books. I think that many of us will be glad to see 2020 in our rearview mirror. I looked back at my quarterly letters starting with last January’s letter. At that time, I was ‘cautiously optimistic’ but for all the wrong reasons. By March, I was justifiably worried and repositioning client accounts. In June, I was noting the rapid recovery at least at the top and the speculative excesses taking place in the market. By September, the markets were back to normal, but we were on the verge of another big surge in coronavirus cases and I was worried about another nationwide lockdown. So far, a nationwide lockdown seems to be off the table, but things continue to get worse. Many hospital systems across the nation are reaching critical capacity with COVID patients. The coronavirus that dominated our headlines has been unrelenting. According to the latest numbers from Johns Hopkins, as I write this note on January 3, there have been 20,451,310 confirmed cases in the U.S. and 350,357 deaths. This means that 1.71% of everyone that contracts COVID will die. By comparison, for the 2018-19 flu season, the death rate was estimated to be 34,200 deaths out of 35.5 million cases or 0.10% mortality.
When the coronavirus exploded on the scene in March, the Federal government embarked on an ambitious plan to develop a vaccine very quickly. Prior vaccines used a weakened or inactivated germ to create an immune response. However, developing that vaccine often took years. Now, using relatively recent technology called messenger RNA or mRNA, a vaccine – actually three different vaccines – has been developed and put through rigorous trials and shown to be 95% effective in a matter of months not years. The rollout of these vaccines is beginning now with front-line healthcare workers and those most vulnerable to the disease starting to receive the first of the two doses of the vaccines.
Despite a year of heartache and death, the markets were relentlessly focused on the future, not the present. We saw the S&P 500 Index hit 20 new record closes this year, closing the year on the last one. The index went from 3,397.16 on August 21 to 3,508.01 on August 28, blowing through the entire 3,400 level in one week. For the year, the S&P 500 Index gained 16.26% which is quite a performance. However, if you will recall my second quarter email, I warned about not equating the S&P 500 Index with “the market”. I pointed out the difference between the S&P 500 Index everyone is familiar with and the equal-weight version of the index. To review, one of the key reasons for the difference in performance between the two indexes is how these securities are “weighted” in the index. In the equal-weight index, as the name implies, each stock starts out at 0.20% of the total account. This is rebalanced on a periodic basis to bring this back into line. The more popular version of the index uses the market capitalization which is the number of shares of the stock that are outstanding multiplied by the price per share. As a stock’s price increases, so does the market capitalization (or market cap for short). I noted the market-cap weighted index had recovered almost all their losses by the end of June while the equal weight index was still down by 12% at that point.
It is a bit instructive to return to these two slightly different indexes again. While the S&P 500 Index was back to new all-time highs by mid-August, the equal-weight version – the one that is more influenced by smaller and mid-sized stocks – did not hit new highs until mid-November. The equal-weight index only hit nine new highs for the year, half of the number of the market-cap weighted index. The equal-weight version was up a respectable 10.42% for the year but this significantly lagged the market-cap weighted version. Where does this leave us at now and where are we heading? Stock prices are still at relatively elevated levels. There are many brokers and investment advisors that will try to bend and manipulate the data to justify the high current prices and valuations. I believe the reasons for the current bull market are twofold – FOMO and TINA. Let me explain.
The first acronym, FOMO, is short for ‘fear of missing out’. This is the greed factor that drives investors to take greater risk, especially when they are following a crowd. This prompts investors to put money into the markets often in the wrong places as they try for that “get rich quick” idea. This can often lead to speculative excesses. Two good examples of this are Robinhood and Tesla.
Robinhood is a financial app that is extremely popular nowadays. It offers access to trade stocks at no cost. Because of the way Robinhood presents itself, it makes investing very “game-like” with confetti and emojis to entice younger investors. This has led to a lot of devastating results with novice investors getting in well over their heads and pouring good money after bad. From an article in the Denver Post it was pointed out that Robinhood traders bought and sold 40 times as many shares of stock and 88 times as many option contracts as their peers at Charles Schwab or E-Trade. Robinhood saw 3 million new users sign up in 2020 and was the fourth most downloaded app on the Apple platform and the seventh most downloaded app on Android phones. With many people working from home or out of work, the 13 million total users had a lot more time on their hands to trade stocks and options on the app. And trade, they did. The revenue Robinhood earned in the second quarter of 2020 – their revenue is driven by the company getting paid based on the number of orders generated by individuals trading – eclipsed all Robinhood revenue earned between 2015 and 2018.
Tesla, as you are probably aware, makes electric cars or EVs (short for electric vehicles). Tesla has been on the leading edge of the EV market and its founder and CEO, Elon Musk is either a genius or crazy, depending upon whom you ask. Tesla, the company is finally starting to do well, having turned a profit in each of its last four quarters. This led to the stock being added to the S&P 500 Index in mid-December, entering as the sixth largest company in the index. While the company is making strides, the stock has been on fire. The stock price moved from a split-adjusted price of $83.67 per share at 2019 year-end to close just over $700 per share at 2020 year-end for a 743% gain for the year. The total market value of Tesla’s stock is more than the next eight largest car companies in the world! Never mind that Tesla only has just over 1% of the total vehicle sales in the U.S. Yes, it can be argued that Tesla’s 54% of the EV market is worth some premium, but the other car companies are not sitting still and their EV sales will eventually cut into Tesla’s sales and market share. Investors seem to be assuming infinite growth forever for Tesla. The bottom line is that Tesla is probably a speculative bubble but remains popular with individual investors because it just continues to increase in price. For now.
FOMO explains much of the speculative excess lately but what is TINA and how does that affect us? TINA is short for “there is no alternative. In a nutshell, with interest rates near historic lows, if investors want any kind of return, their only alternative is to invest in the stock market. As you know, Congress passed the CARES Act back in March in the wake of the shutdown of our economy. This $1.8 trillion stimulus package was designed to soften the blow of the shutdown and get the economy over this hurdle. In late December, another $900 stimulus bill was passed as part of a budget package. In addition, the Federal Reserve has spent nearly $6 trillion in buying bonds. All this money has to go somewhere, and the biggest beneficiary is the stock market.
I know many of you are worried about the speculative excesses I outlined above. At the risk of sounding like a broken record, let me repeat what I said at this time last year. I am cautiously optimistic. The optimism arises from expectations for continued fiscal and monetary stimulus. In other words, I continue to think both the Federal Reserve and the incoming Biden administration will attempt to stimulate growth in the economy and get people back to work through additional spending packages. This may come in the form of more “free money” or it could come in more responsible ways. Ideally, we could finally see spending on our infrastructure – rebuilding our bridges and highway system that is crumbling. This would be a productive way to spur growth but would not be as immediate as a third stimulus check. Regardless of how stimulus comes to us, I fully expect we will see more money from the government to support the economy and to encourage and promote business and employment growth.
On the cautious side of things, I want to again return to what is fast becoming my favorite metric – the ratio of the value of the stock market to the value of our economy. Just to remind you, this metric measures the value of the Wilshire 5000 stock index, the broadest measure of stock values encompassing virtually every publicly traded corporation, to the value of the output of our economy. As of the end of the third quarter 2020, which is the last measure we have available, this ratio stood at 2.01, which is a new record. In other words, the value of the stock market is currently twice the value of all of goods and services our economy produces. I asked last January when the index was much lower if this overvaluation was sustainable and answered affirmatively. I will echo that thought. As long as interest rates remain low and inflation benign, we will continue to see stock prices at these inflated levels.
And speaking of interest rates…. Last January, the interest rate on a 10-year Treasury bond was just above 1.84% but that was still low relative to the 3% yield it hit in October 2018. The recent changes in interest rates have much more to do with market forces than economic issues. During the summer, interest rates hit new lows as investors were seeking the safety of bonds during the uncertainty of the pandemic. The interest rate on a 10-year Treasury bond fell to 0.54% in July before rebounding to about 1.10% today. Much of this increase in yield is due to optimism on the vaccine front and the expectation for more stimulus financed by bond sales. As investors have gotten more optimistic about the economy returning to normal, they have sold bonds and bought stocks. When investors sell bonds, the price of the bond falls which increases the interest rate yield. This is because the interest rate paid on a bond is fixed so the lower the price, the higher the yield you will earn and vice versa.
The interest rate situation is one that I am paying particularly close attention to these days. This is largely because we have a couple of investments that are a bit interest rate sensitive. The two are TRI Point Group, Inc. (ticker: TPH) and Lennar Corp. (ticker: LEN), both of which are homebuilders. Low interest rates obviously help sales but there are other factors that I believe will continue to drive increased sales for these two companies. One key metric is the availability of new homes for sale. This inventory is currently at the lowest level since this data has been tracked. Couple that with a strong demand by buyers and this is a potential long-term winner. We added both names in the third quarter of the year. Changes to client accounts included two new names. We have added exposure to medical supplies distributor Cardinal Health (ticker: CAH) as well as sports retailer Hibbett Sports, Inc. (ticker: HIBB). In both cases, we continued to use options to gain exposure. However, our use of options seems to be diminishing as volatility – one key factor that allows us to earn great returns – is falling and this lowers our profit opportunities. You can expect to see a return to a more normal “buy a stock and hold” strategy.
Of course, if the fundamentals change on something we own, we will not be shy about selling. This past quarter, we eliminated our holdings in ACCO Brands at a small loss as the company’s cash flow fell significantly, raising the risk on our investment. We also eliminated our exposure to construction company Great Lakes Dredge & Dock Co with a nice profit. We earned between 13% - 16.5% return on this investment in a matter of six months depending upon the account. This one was eliminated for falling cash flow, as well. In addition, we have continued to “roll” options we have on a few other securities such as MarineMax Inc (ticker: HZO), SpartanNash Company (ticker: SPTN) and Weis Markets, Inc. (ticker: WMK). By rolling, I mean we bought back an option we originally sold, obligating us to buy the underlying stock and selling another option that is another month down the road. This is adding to our long-term profits by adding additional cash without taking any additional risk.
We continue to seek out new investment opportunities but there are not many that have caught our attention. Perhaps this speaks to the elevated nature of stock prices. The mutual funds we added in the second quarter of the year continue to perform admirably. We continue to research new ideas as they come along, and we encourage you to bring ideas to us as they occur. We know we do not have a corner on investment ideas. We are always willing to look at new ideas you may come across. While we are always open to short-term trade ideas, we much prefer to find good, long-term investments. Boring companies that continue to mint money for us allow us to rest easy at night.
I hope this is the last time I have to say this, but I will again not be traveling to see clients this quarter. With the vaccines now available, I am just awaiting my turn for my two shots. Once I have the vaccine, I will feel far more comfortable traveling. Just because we do not all have the vaccinations yet does not mean we cannot meet face-to-face. I mentioned last quarter that I have added GoToMeeting, 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
© COPYRIGHT 2015. ALL RIGHTS RESERVED.