​July 2022
 
It would seem that everything old is new again.  We are back to inflation rates that we have not seen since 1982 which caused the Federal Reserve to hike interest rates in June by 0.75% which was the largest rate increase since 1994.  This has led to the worst first six months start to the stock market since 1970.  In addition to high inflation, there are signs that we may technically be in a recession currently.  Economists define a recession as at least two consecutive quarters of negative growth in an economy.  For the first quarter of this year, our GDP or gross domestic production, which is the measure of the growth of the U.S. economy, fell at a 1.6% annualized rate.  Early estimates for the second quarter, which will be released around the end of July, indicate the economy may have contracted at an annualized rate of 2.1%.  If that is the case, then we are technically in a recession. 
 
If we are in a recession, this could help the Federal Reserve out with taming the current high inflation rate.  There is an old maxim on Wall Street that the best cure for high prices are high prices.  This makes some sense as people will tend to cut back on spending when prices jump which eventually causes prices to come back down.  The expectation though, is that the Federal Reserve will continue to be aggressive in raising interest rates as their means to combat an inflation rate that is currently running around 8.6% annually.  However, if inflation drops off rapidly, which it could do from the combination of higher interest rates and a recession, the Federal Reserve won’t need to raise interest rates as much as had been expected.  In fact, the expectations for how far the Federal Reserve will raise their benchmark Fed funds rate has fallen from around 3.8% in early June to about 3.2% currently.  There are some that even expect rate cuts in 2023, should the recession continue, and inflation be reined in.
 
In looking at past recessions and how the Federal Reserve responded, the only period that correlates to our current environment is the mid-1970’s.  The U.S. economy went into a recession in the first quarter of 1974 that lasted for about a year through the first quarter of 1975.  During that period, the Fed funds rate started at around 9.75%, rose to just over 13.3% before being cut back to around 5.5% by the end of the recession.  This was also the era of the oil embargo by the OPEC nations which started in October 1973 and ended in March 1974 but saw the price of a barrel of oil rise four-fold from $2.90 per barrel to $11.65 per barrel.  It was this oil shock coupled with easy money and a lack of fiscal discipline, especially around spending to fund the Vietnam War that pushed the U.S. economy over the edge into a recession.  While $11.65 per barrel oil seems quaint now, that would be the equivalent of oil at over $200 per barrel today.  Mark Twain once said that history does not repeat itself, but it does often rhyme.  This would be one of those cases. 
 
The current environment we find ourselves in has echoes of the 1970’s oil supply shock in the pandemic-induced shortage of just about everything.  Add to that the easy money of zero interest rates and the three stimulus checks given out to spur the economy during and post-pandemic and we have a similar situation to the mid-1970’s.  Much of the reason for the current oil supply issues revolve around oil companies dramatically cutting back on what is known as “capital spending” – the money they would spend to explore for and drill new wells or to bring old wells back on-line.  The key reason oil companies are reluctant to spend that money is a long history of “boom-bust” cycles in the oil patch.  It would seem the companies have finally learned their lesson not to ramp up spending just because oil prices have jumped.  In addition, even if more wells were brought back on-line, there is an issue with a lack of refineries to turn the oil into gasoline.  Currently, the refineries we have in the U.S. are operating at about 94% capacity.  The capacity that is not being utilized is due to maintenance and repairs being done to the facilities.  In fact, no new refinery has been built in the U.S. since 1977.  There have been upgrades to some older refineries over the years, but we still lack a capacity to refine much more oil into gasoline.  And no oil company is going to commit to a years-long project and spend over $1 billion to build another refinery of any size with the pressures of investors bearing down on them to reduce their carbon footprint and shift to renewable energy. 
 
All of this has led to a very tough investing environment.  The broad stock market fell over 8% in June alone taking the market down just over 20% for the year-to-date period and putting us in what is generally regarded as a bear market.  Making things more challenging is the fact that many investments that should have done well this year have not performed as expected.  You would think that mutual funds that invest in bonds that take advantage of rising interest rates would be knocking the cover off the ball right now.  Most are down between 1.25% and 1.5% for the year despite three interest rate hikes so far this year.  Even the mutual fund that invests in TIPS – Treasury Inflation Protected Securities or bonds that automatically adjust their value to protect holders from high inflation – lost over 9% of its value for the year!  This has affected our current lone bond holding, the Janus Henderson AAA CLO ETF.  This mutual fund, which invests in the safest short-term loans, has seen its dividend yield increase from around 1% at the start of the year to 2% currently.  However, the share price has fallen a little over 2% since the start of the year, which has dragged down performance. 
 
One of the few areas that has done well has been oil and oil stocks.  While we don’t own any oil stocks (yet), we did make some money by trading in this space.  We sold an option that obligated us to buy shares of Continental Development for $6 per share which we closed early, earning a 4.54% return in a month.  We also obligated clients to buy shares of Occidental Petroleum at $50 per share just before news broke that Berkshire Hathaway had taken a large 7% interest in the company and the share price jumped to over $60 per share.  We still earned a 3.2% return in a month on our investment.  We also made some trades in the United States Oil Fund LP ETF, a fund that is tied to the price of oil using futures.  Over the five-month period that we traded options in this fund, we earned between a 36% and 47% return without risking more than 1% of a client’s account. 
 
We do currently have options outstanding obligating us to buy shares of PDC Energy Inc. (ticker: PDCE), formerly Petroleum Development Corporation.  We are currently obligated to buy shares at $59.50 but given the premium we have collected our cost would be about $57.80 per share.  In addition, we have earned a 3.32% return from selling a previous option that expired worthless.  As much as we as a country need to make a shift to clean, renewable energy, we are not ready to make that leap just yet and oil and some oil companies will continue to do well for the next few years. 
 
We did add two new funds to client accounts this quarter.  We have tiptoed into the Applied Finance Explorer fund (ticker: AFDVX).  We have been familiar with Applied Finance group since shortly after we started our firm.  The Applied Finance Group began as a company selling research on companies to portfolio managers.  They eventually branched out into managing money and then started mutual funds.  The Applied Finance group has what I think is a unique approach to calculating the value of a stock.  They do not use traditional “value” or “growth” metrics that most mutual fund managers box themselves into using.  Instead, they look at what they call the “economic value added”.  That is, does the company they are evaluating create or destroy shareholder value.  They are looking for companies creating shareholder value.  This sort of approach is one that appeals to me and is similar to my methodology.  This fund invests in small companies.  We only have a small position currently but expect us to add more shares on weakness in the markets. 
 
We sold out of the BlackRock Mid Cap Growth fund this past quarter. While we did well in that fund, notching a 40% gain while we held it, this fund was becoming too risky in the current environment.  We began to move to the Janus Henderson Contrarian fund (ticker: JSVAX) for exposure to midsized company stocks.  This fund marches to the beat of its own drummer.  What I mean by that is the fund is happy to find value wherever it can rather than following a particular benchmark.  This has proven to be successful, leading to smaller losses during tough times and better returns during good times.  Again, we have just a small position so far, but expect us to continue to add to this on market pullbacks.
 
We did eliminate three holdings from last year, selling out of Hillenbrand Inc. (ticker: HI) with a 13% loss on this stock.  The company has been showing more weakness lately which prompted the sale.  We also closed out our Hologic Inc. (ticker: HOLX) position for a small 2.32% gain.  Our biggest success came with Sanderson Farms, Inc. (ticker: SAFM), one of the largest producers of chicken.  A partnership of Cargill and Continental Grain agreed to purchase Sanderson Farms for $203 per share in cash.  We originally purchased shares for around $189.70 per share at the end of December.  We expected to lock in a 7% return once the deal closed later this year.  However, in late-June, shares of Sanderson Farms were trading above the $203 merger price, so we sold our shares for just over $210 per share, notching an almost 12% return in six months.  Likely, the market is expecting the merger deal to be modified with additional funds from private equity to get around some governmental concerns regarding too much concentration but in the absence of a definitive deal, we will take the sure thing now. 
 
In addition to the PDC Energy stock mentioned above, we have sold options against several other stocks that we want to buy.  Why are we selling options rather than just buying the stocks outright?  The key reason is that we are taking advantage of the increased level of volatility in the market.  This increased volatility which arises from the uncertainty about what the market will do allows us to earn large premiums from selling an option that obligates us to buy the stock at a set price.  If the stock falls, we end up buying the stock but at a more favorable price.  If the stock doesn’t fall, we still make money from waiting – usually 2% - 3% on the amount we are setting aside for the purchase within a 30-day period. 
 
In our last quarterly letter, we suggested that, if you had excess cash that you could “lock up” for at least one year, you should look into buying a Series I Treasury bond.  This can be done by going to http://treasurydirect.gov and setting up an account to have money drafted from your checking or savings account to make the purchase.  You are limited to $10,000 in purchases per person per year for these bonds.  When we made this suggestion back in February, the I-bonds were paying a little over 7% interest on an annualized basis.  These bonds have their interest rate adjusted twice per year and a portion of the interest rate is based on the current inflation rate.  If you have not taken advantage of these bonds yet, now is a good time to consider them.  The current interest rate on these bonds will be about 9.62% per year.  For those of you that did take advantage of them earlier, you will get this same rate, so you are not missing out on anything.  Again, let me reiterate that you cannot redeem these bonds within the first year of purchase.  After one year and before five years, you can redeem them, but you will lose the previous three months’ worth of interest.  After five years, you can redeem them for their then current value, and they fully mature in thirty years.  We will continue to update you on these bonds.
 
We are currently holding more cash in client accounts than we normally would but much of that cash backs up many of the options we have sold. For example, we sold options that obligate us to buy shares of agricultural chemical company American Vanguard Corp. (ticker: AVD) at $20 per share.  For every 100 shares that we want to purchase (each option represents 100 shares), $2,000 is set aside to make sure we can buy the shares should the stock price drop to $20 or less.  In the interim, we have earned a premium of $31.25 for taking on this obligation.  That may not sound like a lot but that equates to 1.56% in just 24 days.  While I hope to purchase the shares, should we not have to when the option expires in mid-July, we will simply try this same strategy again.  You can expect that we will gradually add more equity names – both individual stocks and additions to mutual fund holdings on weakness in the markets as we do not expect this downturn to be a long-term event.  Unless we are exceedingly lucky, we won’t buy at the exact bottom, but we will generally buy at favorable prices.  You can also expect us to gradually add more exposure to bonds to client accounts, especially as interest rates finally offer a more attractive return than zero percent.
 
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

If you go back to my last client quarterly letter, you will note that I managed to nail what we have seen so far this year.  Increased volatility in the stock market?  Check.  A ten percent correction?  Check.  Higher interest rates?  Check.  Lower stock prices?  Check.  While I did not mention war, anyone who did not seriously think Russia was going to invade Ukraine was fooling themselves.  In early-February, I wrote a note that was posted on our website which addressed some of these issues.  In that blog post (https://www.aeriecapitalmgmt.com/blog), I tried to explain why we had more volatility this year.  Let me address this briefly here.  The answer started with explaining how rising interest rates affected the value of stocks. 
 
How do rising interest rates affect investors?  Let’s start with the fact that stocks represent ownership in a business.  These businesses earn a profit.  Let us look at a very simple problem.  Suppose we own a business that earns $1,000 per year.  We anticipate it will earn this same amount every year until the end of time.  Suppose further someone wants to buy our business from us.  What would we be willing to accept to sell this business?  If we expect to earn the same thing every year and if interest rates are 1% and we do not expect that to change, it turns out we would be indifferent between earning $1,000 each year or receiving $100,000 up front.  These two amounts would provide the same outcome.  In finance lingo, this $100,000 is the “present value of all future cash flows”. 
 
What happens if interest rates go up?  Suppose we can now earn 2% interest on any money we invest today.  As you might suspect, doubling the interest rate cuts in half the amount of money we would need to accept today to earn the same set of cash flows.  In other words, we would be equally happy with $50,000 in hand today or $1,000 per year forever.  Rising interest rates reduce the “present value” of future cash flows.  The value of our business has fallen in half.  The price a stock trades at represents what investors think the present value of future cash flows are worth.  The cash flows, of course, are the future earnings of the companies.  This raises two key questions.  The first is when the Fed is all said and done raising interest rates, what will be the prevailing interest rate?  3%?  5%?  6%?  No one knows.  The second question is what will companies earn?  If Apple earned $6.00 per share last year, is that sustainable?  Might it continue to grow?  Could it shrink if we have a recession?  These two questions – the level of interest rates and the future earnings of companies – are leading to the current levels of volatility.  In other words, if you think Apple will earn $7 next year and interest rates will settle around 3.5%, then you are willing to pay up to $200 per share to purchase Apple stock.  Meanwhile, I may think Apple has stalled out and earnings will not grow but will remain at that $6 per share level.  Further, I think interest rates will climb to 4% when all is done, so I am only willing to pay $150 for a share of Apple.  The disparity between investors beliefs is what leads to volatility.
 
Besides the increased volatility, the other two key issues – both linked to each other – are inflation and oil prices and gasoline prices.  Oil is a key component of the basket of goods that determine the inflation rate so when that spikes, inflation spikes, too.  So when can we expect some relief from this inflation and how will that happen?  Pardon me while I get just a little bit wonky and discuss economics for a bit. 
 
Let me explain just exactly what inflation is and how it is measured.  Inflation is when prices are rising in an economy.  This is measured by what we call the consumer price index or CPI for short.  This index is based on a market basket of goods and services that most Americans use on a regular basis.  Key items, of course, are food, gasoline, housing costs and normal consumer purchases.  The value of each item is measured and compared over time and the change in the value of this basket of goods and services reflects the inflation rate.  Currently, energy costs comprise almost 25% of the value of the index, so a change in the price of oil would have a large impact on the CPI and thus inflation.   Through February, the CPI rose 7.9% on a year-over-year basis.  Energy (fuel oil and gasoline) was up 25.6% and was obviously a major component of the current inflation rate.   
 
Up until the end of last year, I was of the opinion the inflation rate we were seeing last year was “transitory”.  That is, I thought it was an anomaly that would quickly pass as we returned our economy to a more normal state.  Sadly, this is not the case and energy costs are a big reason for this and a major source of controversy.  There are several reasons for the spike in price for oil and gasoline.  Most have little to do with the memes you see on Facebook or hear about from some politicians.  They all want to blame President Biden for canceling the Keystone XL pipeline or for not allowing oil drilling on Federal lands.  Neither of these have anything to do with the current spike in oil prices.  The Keystone pipeline, which brings oil from the tar sands region of Canada down to the Gulf Coast, has been operational since 2010.  The Keystone XL pipeline was to be a shorter route that connected the starting point in Canada to the existing pipeline in Nebraska.  TC Energy, the company that operates the pipeline, touted that the XL pipeline would carry “up to 800,000 barrels of oil per day” but failed to mention that most of that oil would come from the Bakken region in Montana and North Dakota as it ran through that area – oil that is already being shipped anyway.  In other words, the pipeline would not have added 800,000 barrels of additional oil to the U.S. economy contrary to what politicians and memes claim.  There might have been some incremental increase but certainly not to that level. 
 
Congress recently took the oil companies to task for making billions in profits and using this money to buy back their own stock rather than reinvesting in more oil wells.  There is some legitimacy to this claim, but it is a gross over exaggeration.  Yes, oil companies did earn a tremendous profit in the past year.  However, over the past two decades they have had a boom-bust cycle.  When oil prices would climb, oil companies would rush to drill new wells to capitalize on the high oil prices.  This led to more oil on the market and lower oil prices and losses forcing cuts in production which eventually led to less oil production and eventually higher oil prices.  Oil companies may have learned from their past mistakes and are slower to bring new oil wells on-line.  Add to this the loss of over 12,000 jobs in the oil patch from the pre-pandemic high and that adds to the difficulty in restarting old wells or drilling new ones.  The money the oil companies are spending to buy back their own stock is being done because they really have no other place to spend the money that brings added value to shareholders. 
 
Another issue impacting oil production is a shift in sentiment among primarily institutional investors (think mutual funds, large college endowment funds and large pension plans) that encourage a shift to greener energy and less focus on industries that cause greenhouse gas emissions to rise.  This can make it hard for oil companies to raise additional capital for drilling more oil wells.  That may be counterintuitive in light of the fact I just said oil companies earned record profits.  Oil companies will try to spread the risk of drilling new wells by attracting outside investors who share both the expense and some of the profits for drilling these new wells.  Oil companies could do this all themselves but prefer to spread the risk around. 
 
Lastly, we have the war in the Ukraine also impacting the price of oil.  Due to Russia’s invasion of Ukraine, stiff sanctions have been imposed on Russia including on Russian oil.  Russia is the sixth largest producer of oil in the world and currently no one is buying their oil to punish them for invading another sovereign nation.  This has taken about 11 million barrels of oil per day off the market, driving up the price of the oil that is still out there.  Should the war end soon with Russia’s complete withdrawal, the sanctions would likely end, and Russian oil would flood the market driving down the price of oil in the short run.  However, oil would likely settle in the $80 - $85 range (oil is currently around $96 per barrel as I write this) which is where it was before the Russian-Ukraine situation. 
 
With all of this being said, what are we doing about this either to protect clients or to take advantage of the situation?  We made several moves that were designed to protect us from some potential losses.  For example, in early January with inflation being universally acknowledged as an issue, retail stocks were starting to suffer losses.  This makes sense.  Costs for the goods they sell go up.  The stores may not be able to pass along all the cost increases.  That would be a drag on their earnings.  We purchased options that would benefit from a drop in the price of a group of retail stocks.  This proved successful as we generally netted a 25% gain in client accounts in the span of about three weeks.  We also sold options on two separate occasions that obligated us to buy an ETF (exchange-traded fund) tied to U.S. oil as a bet that oil prices were going to continue to move higher.  This is, of course, what happened, allowing us to net 9% the first time and 9.2% the second time we made these trades. 
 
As stock prices fell, more companies became values to us, and we added several new positions this quarter.  We bought shares of Activision Blizzard (ticker: ATVI) for around $80 per share.  Currently, Microsoft has offered to buy the company for $95 per share.  There are a few in Congress who are saber rattling against the merger (Elizabeth Warren and Bernie Saunders, for example) but my expectation is this is a lot of noise and hot air and will come to naught.  We also added shares of consulting company CRA International (ticker: CRAI), industrial company Hillenbrand Inc. (ticker: HI), medical diagnostic equipment manufacturer Hologic Inc. (ticker: HOLX), container shipper Matson Inc. (ticker: MATX), interior electrical wiring company Encore Wire (ticker: WIRE), and residential homebuilder Tri Pointe Homes, Inc. (ticker: TPH) to client accounts.  We also bought shares of Ford (ticker: F) as we viewed this stock as a reasonable way to invest in electric vehicles without taking the risk of the many new entrants into that space. 
 
In addition to these new equity investments, we made some major adjustments to client fixed income (bond) investments.  We eliminated the two bond funds we held as they not only were lagging but promised to be more of a drag as interest rates start rising.  We shifted most of our fixed income investment to the Janus Henderson AAA CLO exchange traded fund.  This mutual fund invests in CLOs or collateralized loan obligations – bank loans – but only those with the highest credit rating.  This results in a slightly lower yield relative to other funds that invest in bank loan debt but more safety.  When we started buying shares, the fund sported a dividend yield around 1.13% but we expect that to increase dramatically this month.  The loans the fund holds are floating rate loans, meaning the interest rates paid on the loans adjusts periodically.  These CLOs reset their interest rates quarterly and are set to adjust in April.  In our conversations with the portfolio managers, he expects the dividend yield to increase to around 2% for the fund.  In addition to this fund, we have found a solid “core plus” bond fund that will be our “go to” bond fund.  We have started with a small allocation of around 1% of client accounts to this fund and expect to gradually scale into this fund as interest rates continue to climb, and we can add shares on periodic price drops. 
 
We weren’t just busy adding new investments this quarter.  We also eliminated a few holdings and trimmed several others.  We sold out of our Atlas Air Worldwide stock earning a 30% return in about a year, eliminated retailer Citi Trends with a small gain in some accounts and a small loss in other accounts.  We trimmed several growth-oriented mutual funds including the BlackRock Mid Cap Growth fund, the Putnam Small Cap Growth fund, and the Putnam Growth Opportunities fund.  We eliminated our holding in the Virtus KAR Mid-Cap Growth fund.  That fund had been a stellar performer for us but had become quite the anchor in the first quarter of the year.  In retrospect, we probably should have trimmed or eliminated these funds sooner and faster as the values of these funds fell, dragging down our performance a little more than we would have liked for the quarter. 
 
At quarter-end, we are in a reasonable position with our stock and bond holdings.  We are being a bit more aggressive in hedging client portfolios with options as well as using option strategies to add income to client accounts.  I would expect to see a few more equity positions coming into client accounts as stock prices continue to be volatile providing opportunities to add good companies at great prices.  As a last note, we recommended to many of you a direct investment in Series I Treasury bonds.  These bonds, which can only be purchased through the website http://treasurydirect.gov , are currently paying a little over 7% interest through May.  The interest rate on these bonds is reset semiannually and is based on the inflation rate.  As the inflation rate is expected to remain above 7% for now, we can expect these bonds to continue to pay at this rate through November.  We will keep you informed on what to do with your I Bond holdings.
 
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