Client Letter 1Q2021
What a difference a year makes! This time last year, we were at the bottom of a long slide down though we didn’t know we had bottomed at that point. Things looked pretty bleak, with millions out of work and businesses closed or closing. Today we are in an entirely different place. Vaccines are rolling out at a furious pace and over 51 million people have been fully vaccinated according to the most recent CDC data. The most recent jobs report rose by over 900,000 which was well beyond expectations. Job growth was strongest in leisure and hospitality, showing the “re-opening” trade is still very much alive and well. The S&P 500 Index, a popular measure of the stock market, closed near its all time high and the first day of the second quarter closed above the 4,000 level for the first time ever. The Federal Reserve is vowing to maintain interest rates at near zero levels and continues to pump about $120 billion into the economy each month. Add to that the $1.9 trillion stimulus package Congress passed and the pending $1.2 trillion in infrastructure spending that is being negotiated and the economy is awash in money seeking investments.
Despite all these good numbers, there are a few caution signs flashing. There are still about 8 million Americans unemployed relative to where we were in February 2020 before the pandemic hit and about 3.9 million fewer people in the labor force. These folks that are out of the labor force are people that essentially lost their jobs during the pandemic and have indicated they have ceased to continue looking for a job. As the economy continues to rebound, it will be important to note whether these folks attempt to return to the labor market. In addition, it is not clear that we will be able to get the 8 million people still seeking jobs employment. The pandemic did a lot to change the way we work. Businesses have learned they can survive with fewer employees. In addition, it is not clear that the jobs that are needed line up with the skills of those who are out of work, making the jobs recovery more challenging.
We have seen interest rates climb rather steeply since the start of the year. This has taken a little bit of wind out of stocks’ sails and has raised fears of inflation and even higher interest rates. Before we start panicking, let me address this issue. During the pandemic, interest rates hit historical lows, largely because no one was borrowing for any reason. One of the key benchmark rates has been the interest rate on the 10-year Treasury bond – that is, a bond issued by the U.S. Government that matures in ten years. Before the start of the pandemic, the interest rate on these bonds ranged between 1.65% and 1.95% before plunging to an historical low of 0.53% in July. We are now back around the 1.65 – 1.70% range so this is not anything to either be surprised about nor alarmed at either. This is just another sign of markets returning to pre-pandemic normality. The big worry will be if this rate continues to creep up well past 2%, making bonds more attractive than stocks.
The rise in interest rates and with a focus on the vaccine rollout and the economy getting back to normal, we saw a shift in investors mindset. This led to a change in investor sentiment from what many pundits described as moving from “growth” to “value”. A better way to explain the shift in investor sentiment would be to say it moved from technology and high growth to infrastructure and lower growth. When you look at the best performing stocks in the S&P 500 Index for the first quarter it is filled with energy (ExxonMobile Corp), materials (Nucor Corp) and industrials (Deere & Co.) while the worst performing stocks included a lot of information technology stocks (Apple Inc), health care (DaVita Inc.) and consumer discretionary (NIKE Inc.). This shift in sentiment both hurt and helped us during the quarter.
Many of the mutual funds we hold across client accounts are very tilted towards ‘growth’ which typically means a higher allocation to technology names and the stocks that have done well through the pandemic. With the change in sentiment recently, many of these funds have stalled and lagged the broader stock market over the quarter. We have still done very well over the past year and I expect these funds to continue to perform well providing they continue to find sectors that are growing. We did make one change right at quarter-end, paring back dramatically on the Putnam Growth Opportunities fund (POGAX) in many client accounts. The accounts we trimmed also held the Janus Henderson Balanced Fund (JABAX) as our “core” holding. As it turns out, the Putnam fund and the Janus fund duplicated each other across most of their top holdings. This exposed us to too much risk especially in the tech sector. We chose to cut the allocation to the Putnam fund in half, which dramatically lowers the risk we are taking in client accounts. Please note that I am not saying that either fund was “bad”, just that having both funds in the same account meant we were too exposed to some stocks. The other mutual funds we hold continue to do well and we will continue to monitor them and make changes as appropriate.
We benefitted from the shift in sentiment through many of our individual equity holdings. Most of the individual stocks we own are in far less glamorous industries. We do have a reasonably large bet on the housing market given our exposure to Tri Pointe Homes (ticker: TPH), Lennar Corp (ticker: LEN) and Beazer Homes USA Inc (ticker: BZH) which we added this past quarter. Other new purchases we made this quarter were also in rather mundane industries. We added Primoris Services Corp. (ticker: PRIM) which is involved in building and maintaining pipelines, gas, water and sewer systems for cities and infrastructure construction. Another new purchase for the quarter was Atlas Air Worldwide Holdings (ticker: AAWW) which buys and leases aircraft for everything from charter flights for tours to freight forwarders and e-commerce retailers (think Amazon here).
The key question at the end of a quarter is always “what comes next?”. At the risk of being redundant, I am still cautiously optimistic. I know I say this seemingly every single quarter, but it remains true. I believe many of the more popular stocks are overvalued, but I also think we are still in a TINA world – there is no alternative. Much of the stimulus money from last year already found its way into the markets and I suspect much of the recent $1.9 trillion stimulus package will soon find its way into stocks. I remain convinced the market is essentially in a “liquidity bubble”. The only reason for the current stock market valuation is the extreme amount of liquidity due to stimulus money and the Federal Reserve. The Federal Reserve is contributing to this bubble by purchasing $120 billion worth of bonds every month. I am convinced this will continue as long as the Fed continues down its current path.
We have already seen a couple of attempts in past years by the Federal Reserve to either cut back on buying bonds or to raise interest rates. The first attempt to cut back on the bond buying in 2013 did not end well. When the Federal Reserve finally stopped the program in October 2014, the market largely ignored the event. Many pundits compare ending this bond buying program, officially referred to as “quantitative easing” or QE, as taking away the punch bowl in the middle of the party. The most recent round of QE was begun in September 2019 and ramped up in March 2020 in response to the COVID pandemic. The only time interest rate hikes have not gone over well was when current Fed Chair Jerome Powell raised interest rates for the fourth time in December 2018 and indicated he expected two or three more hikes in 2019 which was not what the markets wanted to hear. After markets fell precipitously, Chairman Powell quickly reversed course.
With this background, I would not anticipate Fed Chair Powell stopping the bond buying or raising interest rates at any point before 2022 at the earliest. In some recent testimony before Congress, he has gone so far as to indicate he is unlikely to do anything until 2023 based on his current projections. Frankly, the artificial inflation of our economy is not sustainable. As much as I understand the underlying principles involved, the diehard Keynesian in me says that enough is enough and as we get back to normal, we need to run balanced budgets and pay off debts. How this situation ends remains to be seen but that is likely some time down the road. For the short to intermediate term, our best course is to stay focused and not panic when we have small market corrections. For just over the past decade, the best course of action has been to “buy the dips” and until mindsets change in Washington, this will continue.
As always, we truly appreciate the trust you have placed in us, and the opportunity you have given us to manage a portion of your assets. If you have any questions or need to discuss any issues, please feel free to give us a call.
Alan R. Myers, CFA
President / Senior Portfolio Manager
Aerie Capital Management, LLC
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