​Another quarter down and yet more volatility and uncertainty.  Markets tend to be forward-looking and anticipatory of things to come.  This largely comes from FOMO – fear of missing out.  No one wants to miss the boat when the market turns higher.  So investors attempt to predict and make bets based on these predictions.
 
During the first quarter, the Fed continued to raise interest rates, raising them twice but only by one-quarter of a point in February and again in March.  This left the Fed funds rate in the range of 4.75% - 5.00% at the end of March.  Despite these interest rate hikes, the yields on Treasury bonds actually fell for the quarter as investors seemed to be anticipating rate cuts from the Federal Reserve and sooner rather than later.  Frankly, I expect one more interest rate hike in early-May by another 0.25% leaving the Fed funds rate at 5% - 5.25%, which is where Fed Chair Jay Powell has indicated he thinks rates should be at a minimum to curb inflation.  Let’s look at what investors are seeing and how this has played out in the markets. 
 
At the start of the year, the inflation rate as measured by the CPI or Consumer Price Index had fallen steadily since peaking at just over 9% in June to 6% in February.  There seemed to be two narratives that gave investors hope.  One was that inflation was falling rapidly and would be under control soon.  This would cause the Fed to start cutting interest rates.  The other narrative was that the Fed, by continuing to raise interest rates, would cause a recession and would need to cut interest rates in response.  In both cases, the idea of falling interest rates plays a key role. 
 
We saw this anticipation of rate cuts being played out across both stock and bond markets.  In the bond market, interest rates on Treasury notes and bonds fell during the quarter, dropping by 7% - 9% during the quarter.  At the start of the year, the interest rate on 2-year Treasury notes, for example, were around 4.41% but ended the quarter at just over 4% even.  The interest rate on 30-year bonds fell from just under 4% in December to 3.69% at the end of March.  We can tell a lot about market psychology from the interest rates we see on bonds with different maturities and how these bond yields (interest rate) change over time.  By the end of the quarter, the bond market was anticipating the Fed would cut interest rates by the end of the year.   
 
This tumble in interest rates was accompanied by a rally in the stock market, especially among “growth” stocks.  The key reason for this is that when interest rates are low, companies that have low debt and higher cash flows see their stock prices become more valuable.  We saw this play out as the S&P 500 Index rallied 7.46% for the quarter while the tech-heavy NASDAQ 100 Index gained a whopping 16.77% for the quarter.  Volatility in the stock market was relatively muted until mid-March when we suddenly encountered a banking crisis.  Actually, that should be banking “crisis”.  There was really only one bank in crisis that did lead to a second bank that failed but the idea that we have systemic problem is ludicrous.  I will come back to this in a bit. 
 
Where do we stand in this current environment?  I have been adamant that I believe what Fed Chair Jay Powell has been saying all along.  We are going to see at least one more rate hike and then likely a pause to give the markets a chance to catch up to their policies.  Barring some major exogenous event, I do not see the Fed cutting interest rates this year.  I believe we won’t see interest rate cuts until at least the end of the first quarter of next year.  I don’t see inflation falling to the 2% target very quickly, especially given the issues in the labor market.  In a nutshell, the Federal Reserve is extremely worried about this current inflationary environment being a repeat of the late-1970’s era inflation.  That was a time when we had wage and price spirals going.  Wages for workers would go up, which caused companies to have to raise prices, which caused a new demand for higher wages which led to higher prices and the circle seemed endless.  What broke that cycle was when the Fed under then chair Paul Volker dramatically raised interest rates (anyone remember 15% CD’s and 18% mortgages?) which ultimately stopped this cycle and brought inflation back down to a more normal 3% - 4% range.  The current Fed is laser-focused on this very scenario.  My fear is that they are misinterpreting the situation.  This labor market is not like the one in the 1970’s for many reasons.  The biggest reason is that that labor market had a larger supply of people to tap into than we do now.  Everyone that entered the work force at that point is either retired or retiring and we just do not have enough people to replace them.  This lack of supply of workers will keep wages high but I believe businesses will be limited in how much they can raise prices when most of their consumers are retired and on fixed incomes. 
 
Since the likelihood is that interest rates are going to stay higher for longer, this means the stock market is likely overvaluing stocks.  I think we will see stock prices fall but I do not see a significant meltdown.  I have been saying for the past year that we are in a broad range on the S&P 500 Index between 3,600 and 4,100 and that still seems to be accurate.  At the end of the quarter, the index stood just over the 4,100 level which lines up with my thesis.  So far.  I don’t get too excited when the market hits that 4,000 – 4,100 level and I don’t panic if we fall to the 3,700 – 3,800 level. 
 
The one fly in the ointment that could change the speed at which inflation comes in is the banking “crisis”.  Let me clarify what happened here.  There was a bank – Silicon Valley Bank – that had been growing tremendously, focusing on tech start-up companies in Silicon Valley in California.  The bank’s assets had essentially tripled in size in the past three years, with most of the deposits being corporations rather than individuals.  Banks will typically invest their excess funds into reasonably safe investments such as government bonds.  This bank, during the pandemic, bought 30-year Treasury bonds which are one of the safest investments around.  At the time these were purchased, interest rates were still near zero so these bonds, paying about 3% interest, seemed reasonable.  Then, in 2022, the Fed started raising interest rates.  A basic principle in finance is that bond prices and interest rates are inversely related.  That is, if interest rates go up, the price you can sell a bond you hold will fall.  Conversely, if interest rates fall, the price you could sell a bond you hold will increase.  With interest rates rising these 30-year Treasury bonds that Silicon Valley Bank held tumbled by as much as 20% in value.  These were the worst investments they could have held in a rising interest rate environment.  At the same time as their portfolio of bonds was falling, many of their depositors were looking to move their money to other banks offering to pay more interest.  This caused a “run” on the bank meaning the bank did not have enough liquidity to pay out all the depositors wanting their money.  This happened over a weekend in early March.  The Sunday night after Silicon Valley Bank was essentially declared insolvent, I happened to turn on my TV and it was on the business network CNBC at the time.  They had a “special report” entitled “BANKING CRISIS IN AMERICA” and I thought “what are they talking about?”.  There was one other bank – Signature Bank in New York – that also got caught up in this “crisis”, but in fairness this bank was very involved with cryptocurrency which provided additional risks.  Much of this “crisis” is in the fervent minds of the media who need headlines.  Because of the failure of Silicon Valley Bank, there are likely to be additional regulations that may limit some lending by these regional banks.  The outcome of these new banking regulations will have a similar effect to additional interest rate hikes which may help curb inflation sooner.  However, I still do not think we are going to see a 2% inflation rate this year and the Fed has been very clear on their goal. 
 
With all of this as background, how are we positioning clients for this current environment?  We made minimal changes this quarter.  We are still focusing on “value” versus “growth” as we continue to believe the market is misreading the signals.  We have made a very slight modification to our screen, adding a filter for very high free cash flow to find great companies worth investing in for the long term.  We remain focused on solid companies that continue to grow sales at a reasonable rate and have strong free cash flows they can use to either reinvest into the company, pay dividends, buy back stock or all the above.  We only made two changes of significance during the quarter.  We eliminated our holdings in the Invesco DB US Dollar Index Bullish fund (ticker: UUP).  This fund took advantage of the U.S. dollar being stronger than other currencies which was a result of the rising interest rates.  With that coming to an end and with other countries now raising their interest rates, this fund had run its course, so we sold our entire position.  
 
The other big change we made this quarter was to make a switch in our core balanced mutual fund.  Previously we had been using the Janus Henderson Balanced fund (ticker: JABAX) which is a very good fund.  However, the only reason we used that one was that our all-time favorite balanced fund, the T. Rowe Price Capital Appreciation fund (ticker: PRWCX) had been closed to new investors.  In late February, Capital Appreciation began a limited re-opening and we jumped at the chance to move everyone over from the Janus Henderson fund to the TROW fund.  This fund – what we refer to as a 50% - 70% allocation fund, meaning it will be at least 50% invested in stocks and up to 70% invested in stocks with the balance in cash and fixed income – is the best performing fund of its kind over the past 3-, 5-, and 10-year periods.  As long as the current manager remains at the helm, this will be our “go to” core fund.    
 
Aside from this core fund, one of our largest investments across client accounts continues to be the Janus Henderson AAA CLO fund (ticker: JAAA).  This fund invests in portfolios of senior secured loans with floating interest rates.  At present, this fund is yielding about 5.6% but this is expected to climb to around 6% next month when the interest on the loans in the portfolio are adjusted.  This started out as a place for us to “park cash” and was one of the few investments that was profitable last year.  This fund continues to do well for us, gaining about 1.39% for the first quarter.  I have mentioned in the past that as interest rates peaked, we wanted to find places to “lock in” higher yields.  However, it does not appear that we can do much better than we can in this fund. 
 
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.
 
Sincerely,
Alan R. Myers, CFA
President / Senior Portfolio Manager
Aerie Capital Management, LLC
(866) 857-4095
www.aeriecapitalmgmt.com
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​ 
We have finally come to the end of a tough year.  This was a year in which there were few, if any, places to hide from the carnage.  Stocks tumbled as much as 25% before bouncing in the fourth quarter to end down 19.4% for the year.  Normally bonds provide at least a cushion to soften the blow, but the numerous hikes in interest rates by the Federal Reserve meant that, while bond yields (the interest rate you can earn on a bond over its life) rose dramatically, the price of bonds fell dramatically.  This means if you held a bond mutual fund at the start of the year, it likely fell around 12.9% for the year.  And the operative watchword for the year was “inflation”. 
 
The inflation rate peaked at 9.06% in June before starting to slowly retreat.  However, by the end of November, it was still at 7.11% - well above the 2% - 3% range the Federal Reserve is targeting.  This has led the Fed to hike interest rates from a range of 0% - 0.25% at the start of the year to 4.25% - 4.50% by December.  We are likely to see a couple of additional rate hikes in 2023 with the expectation being a Fed funds rate of around 5% before interest rate hikes pause. 
 
Inflation is expected to continue to trend down over the next year, but we are not likely to be back at the Fed’s stated goal of 2 – 3% soon.  This will mean that interest rates will be “higher for longer”.  In other words, welcome to the 2000’s.  Interest rates on Treasury bonds are essentially back to the levels prior to the Great Recession.  The International Monetary Fund (IMF) has estimated that global inflation will decline to around 6.5% for 2023 and to 4.1% by 2024.  This argues that interest rates are going to stay elevated through all of 2023 and well into 2024 before there is any chance for relief.  I fully expect the Fed to hike interest rates at their next meeting at the end of January with possibly the last raise coming in March.  If that happens, you will see us start to gradually shift our current bond fund mix from funds that are focused on very short-term, interest rate sensitive bond funds to ones that can “lock in” those higher interest rates for the long term. 
 
In addition to higher interest rates, which are typically a drag on stock returns, we are beginning to see companies laying off workers.  The majority of these layoffs are in the companies that were beneficiaries of the pandemic and the “work from home” trends of the past two years such as DoorDash, Amazon and Peloton.  While some of the numbers sound scary, we need to keep things in perspective.  News media will try to spin things to sound sensational.  Amazon is laying off 18,000 workers.  This is only about 1.1% of their total workforce, though.  DoorDash is laying off 6% of their workforce which totals about 500 people.  Facebook parent Meta is laying off 13% of their workforce or about 9,300 people which is about half of the number they hired during 2021. 
 
These layoffs are certainly something to take note of when it comes to business and the economy.  Many companies overstaffed in the face of boom times during and just after the pandemic.  As I write this letter, the December jobs report has just been released showing continued strength in our economy.  The unemployment rate ticked down slightly to around 3.5% while wages ticked up 0.3% for December.  Wage inflation is a problem that can throw a monkey wrench in what the Fed is trying to accomplish.  In addition, there are still about 10.5 million job openings in the U.S. currently. 
 
Many of the people being laid off from these companies will be able to find other work, though it may not necessarily be at the same pay scale or in the same field.  And there will be some skill mismatch – engineers not wanting to move to retail sales, for example – but all indications are that the Federal Reserve is going to be able to engineer what economists call a “soft landing”.  What the Fed wants is for the economy to slow down to rein in inflation.  This is usually caused by a recession.  In a “soft landing” situation, the economy manages to avoid a deep or long recession.  I would submit that, given the labor shortage we currently are experiencing, any recession we have will not be your father’s recession.  Unemployment is not likely to rise much above the 4% range – well below the 6% - 8% range for most of the past recessions. 
 
So what worked this past year and what did not work?  The one thing that did work was oil and gas.  Between inflation, a relative return to a normal world and the Russian invasion of Ukraine, oil spiked from around $75 per barrel at the start of the year to as much as $120 per barrel by June before returning at year-end to about where it started.  Oil stocks were all the rage.  In fact, if you look at the best performing stocks in the S&P 500 Index for the year, oil stocks were nine of the top ten and 14 of the top 17 performing stocks before you start to get to a more diversified list of companies.  Very little else worked as the only other sector to have a positive return for the year were the utility companies and only by DA1.65% for the year.
 
The three sectors that were off the most were communication services (Google parent company Alphabet, Facebook parent company Meta, Disney and Netflix, for example) which was down almost 41% for the year, consumer cyclical stocks such as Amazon, car dealers and travel and leisure companies with this sector off about 35% and technology stocks which tumbled 31.55% for the year.  All of these sectors and most of these stocks fell into what advisors often call “growth” stocks.  Growth stocks benefit when interest rates are low.  The fact that these sectors fell as much as they did should not be a surprise in light of the interest rate situation. We managed to avoid individual stocks in these sectors during the year.  The only exposure we had was through some of the mutual funds we held.  We did cut most of our holdings in these funds throughout the year, but our one regret was not eliminating them all earlier in the year. 
 
More important than what did or didn’t work this past year is what will or won’t work for the next year or two.  Much depends upon how the economy shapes up, of course, but we have some clues based on history.  As Mark Twain once said, “history doesn’t repeat but it often rhymes.”  We have been going back through history to find time periods that were similar, though, in many ways, this time really is different.  Structurally, the U.S. is in a different place now than it ever has been in history.  That aside, there will be parts of the economy that “rhyme” with the past giving us clues as to what may and may not work. 
 
As for client accounts, we avoided a lot of trading in the fourth quarter.  The biggest moves we made involved the reallocation of fixed income holdings.  We have finally settled on four different funds to use for exposure to fixed income (bonds).  With rising interest rates during the year, this has been a tough sector to find what works.  The four funds we are using include two that take advantage of rising rates by investing in bonds or loans that have adjustable interest rates.  As interest rates increase, the income from these bonds or loans increases, leading to higher income to us as shareholders and a bit more stable price. 
 
The two funds that benefit from rising interest rates are the Janus Henderson AAA CLO fund (ticker: JAAA) and the Wisdom Tree Floating Rate Treasury fund (ticker: USFR).  Both funds ended up for the year with JAAA gaining 0.53% and USFR up 1.98% for the year.  In addition to these two funds, we added two new funds to the mix.  One is a nontraditional, “go anywhere” bond fund from T. Rowe Price.  It is the Global Dynamic Bond fund (ticker: RPIEX) and this fund was up 3.6% for the year.  The last fund we are using in our fixed income mix is not exactly what most investors would think of when it comes to “fixed income”. 
 
When it comes to investing in fixed income securities, the idea is to earn a reasonable rate of interest that compensates for the risk over the time period you are holding the investment.  If you buy a three-year CD, for example, you will want to earn a higher rate of interest per year than if you bought a one-year CD.  The same should hold if you bought a bond that matures in five years.  You would likely ask for a higher interest rate than for the 3-year CD or bond.
 
The fund we are using is the First Trust Vivaldi Merger Arbitrage fund (ticker: MARB).  This fund invests in merger deals.  These are deals where one company makes an offer to buy another company.  When this happens, the price of the stock of the company being acquired will usually jump but there will still be a difference between the current stock price and the ultimate purchase price.  As you get closer to the time when the deal will close, this gap narrows.  Buying shares of the company to be acquired is a lower risk way to hopefully earn a fixed return.  This return is usually related to prevailing interest rates rather than stock market performance.  These types of investments have a low correlation to how the stock market performs and generally much less risk during down markets.  In fact, this particular fund was up 3.89% for the year. 
 
The only other significant trade we made was eliminating our holding in Ingles Markets (ticker: IMKTA), a regional grocery chain.  We sold out of that near the end of November for about a 57% profit in a little more than the year we held the stock.  It’s not that the company was doing anything wrong, but the price was getting well above what we calculated as its fair value.  If things change, we will consider re-entering the position.
 
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.
 
Sincerely,
Alan R. Myers, CFA
President / Senior Portfolio Manager
Aerie Capital Management, LLC
(866) 857-4095
www.aeriecapitalmgmt.com