I have been reading a great book recently that touches on much of the psychology behind many of the investing decisions and errors that investors make.  The book, Thinking, Fast and Slow by Nobel prize winner Danial Kahneman, is a user-friendly narrative behind his thinking and research that led to the development of the field of behavioral economics.  One of the things Dr. Kahneman points out – and something I have been saying for a long time – is that we as investors are hard-wired to put a narrative to events.  This is an attempt to put order to an often random and chaotic world. 
 
We have had a volatile stock market since mid-September with any number of narratives to help explain what is going on and why investors are selling.  No, buying.  No, selling again.  First it was Chinese real estate developer Evergrande’s potential bankruptcy.  Then the Federal Reserve calmed fears by confirming what they have been saying all along – they will start tapering sooner rather than later and will follow that up with interest rate hikes.  Next it was hotter than expected inflation numbers.  So many headlines and so much confusion.  Let us try to sort this out a bit.
 
There are really two emotions that drive the market – fear and greed.  When fear is high enough, people will sell anything and everything.  Oftentimes financial advisors will talk about owning “uncorrelated assets”.  The idea is to own two different investments that will move in different directions when things get rough.  A simple example would be owning an airline stock and an oil company.  Since one of the major costs for an airline is their fuel costs if the price of oil increases this will hurt the airline’s profitability and presumably the stock price.  However, the oil company obviously benefits from this price increase as should their stock price.  The stock prices should move in opposite directions when the price of oil changes.  However, when fear rises, investors tend to ignore fundamentals and sell stocks indiscriminately.  We often see investors selling both their airline stocks and their oil stocks at the same time.  In “finance-speak” we would say that all assets have become highly correlated. 
 
The opposite effect occurs when greed is high.  Investors tend to rush out and buy regardless of the outlook or underlying fundamentals.  Oftentimes investors will create a narrative that justifies outrageous valuations.  Sometimes investors have no other choice.  This would explain the world of investing since the Great Recession.  The Federal Reserve lowered interest rates to effectively zero.  This was done to prod businesses to borrow money to invest in building new plants and buying new equipment to spur growth in the economy.  The economy did grow but never at the rate that anyone wanted nor expected though this should not have been a surprise.  Of course, one side effect of low interest rates is that people who rely on earning interest on their investments effectively earn nothing.  This forces investors to seek returns elsewhere. The only alternative has been to invest in stocks for growth and dividends and growth is what investors got. 
 
Since the 2009 post-Recession low, we have seen the stock market pull back on a few occasions.  There were often external forces or headlines at work, but the reality is that investors were just more fearful.  The first instance was in 2011 when Greece faced a debt crisis with the threat of bankruptcy and investors feared another 2008-like debt crisis.  This was also the first time the U.S. balked on raising the debt ceiling and credit rating agencies downgraded U.S. Government debt from an almost risk-free AAA bond rating to AA+ debt rating.  As a side note, as I write this, we are currently facing this very cliff again.
 
We again faced down fear in late-2015 through early-2016 when China’s growth rate was slowing, and oil prices were falling.  This proved to be a short-lived “crisis” as greed again soon took over and by March we were back to where we started.  Fear was stoked again in the fourth quarter of 2018 as we were embroiled in a damaging trade war with China and the Jerome Powell-led Fed raised interest rates for a fourth time for the year and indicated more was to come the following year.  Just a few days into January 2019, Powell was speaking to the American Economic Association and walked back the interest rate hike just a month earlier and indicated he was inclined to cut rates rather than raise them again.  Fear was erased, and greed took over again.  Lastly, there was, of course, the 35% losses sustained in March 2020 when the COVID-19 pandemic shut our economy down completely but by July all losses had been completely recouped as fear of an extended economic shutdown disappeared, replaced by hope life could return to normal sooner rather than later.
 
While the stories that have been spun during these corrections have all been different, the outcomes have been the same.  Fear in the short-term drives markets down until greed takes over and we are quickly at previous levels and higher.  There may also be a hint of “FOMO” – fear of missing out on gains.  In our current economic environment with very low interest rates, we remain in a “TINA” world – there is no alternative.  Investors who want any kind of return are forced to take higher levels of risk than might otherwise be prudent in a more normal world.  This is likely to remain the case until the Fed raises interest rates significantly.  Since the end of the Great Recession, investors have always been rewarded for “buying the dips”.  After one of the more recent pullbacks, I was chatting with a client about his worries over the markets.  He mentioned to me conversations he had recently with his son who actively trades options.  His son, my client told me, had urged his father to sell everything and “go to cash” until the market bottomed.  “That’s perfect!” I replied.  “And just when will the market bottom?”  His son had apparently not given him any figure for how far down he expected the market to tumble.  Our fear leads us to think that every time the market starts to tumble that it is different this time and the start of the financial apocalypse.  At some point, greed kicks in, we are afraid of missing out on future gains, we convince ourselves that stocks are ‘cheap’ again and markets correct themselves.    
 
What could raise the fear factor for investors enough to make a difference?  The biggest boogey monster currently is inflation.  The inflation rate is measured by what is known as the consumer price index or CPI.  The CPI measures the change in the price of a basket of goods and services typically used by a normal household.  The CPI is measured on a year-over-year basis.  Since we are now comparing prices this year to the same time last year when we were just emerging from the pandemic economic shutdown, you can imagine that prices have climbed dramatically as we return to a more normalized setting.  The inflation rate has been running “hot” as the economists say, with the CPI growing at an annualized rate of 5.4% per year.  This is the highest level since around 1990.  There are two questions about the current level of inflation.  The first question is how real this rate is and the second is how long this higher inflation rate last. 
 
There is some question about how realistic this current inflation rate is given that we are essentially comparing apples to oranges.  Of course inflation is higher this year.  Everything was shut down most of last year.  Oil, for example, is a component of the CPI and comparing the October 2021 price of oil to the October 2020 price of oil, the price is up almost 87% year over year.  If you go back a year and compare the current price of oil to the same period in 2019, however, the current price is up about 39% over the same 2019 period.  While that is a jump, it is not as significant a jump.  Personally I think inflation is higher than the Fed would like but lower than what the CPI indicates.
 
As for the question about how long this higher inflation could last, that question is a bit trickier.  Part of the reason for the higher inflation rate is the increased costs to businesses as shelves are restocked.  We have a supply chain issue, and this is driving both the inflation rate and the potential length of time for inflation to remain elevated.  When the pandemic hit, businesses around the world shut their doors to slow or halt the spread of the virus.  This led to empty store shelves as people panicked and bought a year’s supply of toilet paper and soup.  Most goods are now manufactured overseas, largely in China.  Now, as manufacturers attempt to increase production to get things back to normal, they are running into a shortage of enough workers to run the lines.  Assuming the goods get made and out the door, there can be a delay loading containers on the ships for export.  Once the ships arrive in the U.S., there is a backup of ships waiting to dock to unload and even if they get to dock, there is a lack of people to unload the ships.  Once unloaded, the goods are shipped out via railroad to be later transferred to trucks to be hauled to the stores.  Railyards are backed up with containers to be unloaded from trains and put on a trailer.  There is a lack of trailers and even if we had enough trailers, there is a lack of truck drivers.  All along the way, costs are added by shippers to cover these additional costs.
 
There is also a shortage of the materials used in production.  Auto manufacturers, for example, cannot get the microchips they need to build cars, forcing them to idle some assembly lines.  This has led to a shortage of new cars which drove up the prices for used cars as well as the cost for car rentals.  Businesses are having to pay higher wages to find workers for everything from the manufacturing line to the cash registers all of which will translate into higher costs.  Businesses will either have to accept lower profits or raise prices leading to contributing to the inflation picture.
 
Most economists thought the blip in inflation this year would be a relatively short-lived phenomenon.  Many, including Fed Chair Jay Powell, are now saying this higher inflation rate could last longer than first anticipated.  Some economists are arguing higher inflation is here to stay based on the increasing wages and unfilled jobs.  A few economists are evoking a blast from the ‘70’s – stagflation.  Stagflation is an economy in which growth is low or stagnant and prices are increasing at high rates.  Frankly, I am not worried about this scenario but just the very thought of the potential for stagflation to return raises a certain fear level among some investors. 
 
The more likely scenario is one in which the inflation rate continues at a relatively high level above the Federal Reserve’s target rate.  Chairman Powell has always maintained that he thinks an inflation rate of 2% per year is reasonable and healthy but he is willing to let the inflation rate “run hot” – that is to have an inflation rate above the 2% per year level – for a short span of time.  His view is that the rate should moderate over time.  The danger is that inflation runs hotter for longer.  If that were to happen, the Federal Reserve would want to reign this in.  The chief method the Federal Reserve uses to control high inflation is to raise interest rates. 
 
This scenario of higher inflation for longer should be the biggest fear for investors.  If inflation does continue at this hot pace, the Federal Reserve will be forced to raise interest rates both sooner and faster than they have intended or indicated.  As interest rates increase, this does two things.  First, it increases costs for businesses.  Second, it begins to create investment alternatives to stocks that may be more attractive.  If an investor is asked to choose between a stock paying a 2.5% dividend or a bond that matures in ten years paying 1.5% interest per year, the stock wins.  If I have the choice of a bond that is paying 3.5%, interest per year now I have a tougher choice.  Ultimately, many investors will abandon the volatility and risk of stocks for the relative safety of bonds, and this will drive the price of stocks down. 
 
This is a scenario that I am paying close attention to for client portfolios.  Across all client accounts, most of the mutual funds we own have been focused on “growth” stocks.  This has served us well as these are the stocks that have benefitted the most from this current environment.  These will also be the stocks that may suffer should this environment change.  Let me be clear.  I am not expecting an imminent or immediate meltdown in stock prices.  I do think we could see the S&P 500 Index eventually retreat from their current levels.  If the Fed is raising rates, this retreat would last longer.  With this expectation in mind, you will see me gradually cut back on our exposure to these growth mutual funds and reallocate to investments that are better positioned to weather the storm and continue to grow. 
 
This past quarter, we made a few changes across client accounts.  We sold off our holdings in homebuilder Lennar Corp. as valuations of some homebuilders are starting to get a bit stretched.  We also sold our holdings in food distributor SpartanNash, earning just over 6% return in about four months.  On the flip side, we bought shares in medical products and imaging supplier Hologic, Inc. (NASD: HOLX), diagnostics and testing company Quest Diagnostics Inc. (NYSE: DGX), regional supermarket chain Ingles Markets Inc. (NASD: IMKTA), and timberland REIT (real estate investment trust) PotlatchDeltic Corp. (NASD: PCH) which comes with a 3% dividend yield.  We were able to find more bargains during this more volatile quarter.  We also continued to make extensive use of options to enhance our returns – either by selling call options that obligate us to sell a stock in exchange for a premium or by selling a put option that obligated us to buy the underlying stock at the stated price.  Both strategies served us well during the quarter. 
 
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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The operating watchword for this past quarter was “inflation”.  We were preparing to hear from the Federal government on their measure of inflation and the only question was “how high”.  Prices have been steadily increasing as we slowly return to a more normal post-pandemic economy.  Everyone knew inflation for the first quarter of this year would be high.  After all, we were comparing current prices to the first quarter of last year when the economy was shut down.  We were comparing apples to oranges. 
 
The inflation rate for April came in a 4.2% and then rose to 5.0% for May, significantly above the 2.6% rate for March and the 1.2% average for all of 2020.  When the quarter started, the interest rate on a 10-year U.S. Treasury bond was 1.746% which was significantly above its pandemic low of a 0.538% interest rate.  This interest rate reflected investors’ fears that inflation was imminent, and the Fed might raise interest rates to combat this problem.  The key question argued between economists and investors was whether this high inflation rate was real and sustainable or, in the words of most economists “transitory”.  Federal Reserve Chairman Jay Powell is in the latter camp, which has led him to not react to these high inflation numbers.  Let me explain.
 
During a recession, no one is spending any money.  There is no incentive to spend now as prices are likely to fall tomorrow making the goods or services you want cheaper.  To spur spending, the Federal Reserve would lower interest rates.  The chief idea would be for businesses to see a low enough interest rate to incentivize them to borrow money to buy land, build new plants, buy new equipment, and hire more workers to “jump start” the economy.  This has been one of the main tactics during the past two recessions – the 2008 housing bubble and the recent pandemic economic shutdown.  The Federal Reserve lowered interest rates to basically zero on the shortest-term loans to drive investment.  It has not worked exactly as planned, but that is another story.    
 
On the flip side, when there is inflation in an economy, prices are rising, often rapidly.  When inflation exists, the incentive is to spend money now before it loses its value.  Inflation also drives people to borrow money now to buy big ticket items now (houses, cars, appliances) before their prices are out of reach.  If things get out of control, we have what is called hyperinflation.  The poster child for this phenomenon was Germany post World War I.  There are several stories out of this time about how quickly prices could change, even over lunch.  There is the story of a student at Freiburg University who ordered a cup of coffee at a café.  The price on the menu was 5,000 Marks.  He had two cups.  When the bill came, it was for 14,000 Marks.  He was told that if he wanted to save money and have two cups of coffee, he should have ordered them at the same time (from Paper Money by “Adam Smith”).  To stop inflation, the Federal Reserve would raise interest rates charged to banks, forcing banks to raise interest rates they charge their borrowers.  If interest rates reach a high enough point, it will “choke off” this borrowing and sanity will be restored to the economy. 
 
For anyone that lived through the high inflation of the late-1970’s and early 1980’s, the fear of high inflation is very real.  Let me be clear here.  I do not expect a return to those inflationary rates.  That was largely caused by the oil supply shock which dramatically and unexpectedly increased the price of oil very quickly.  This sent shockwaves through our economy which was largely built on using oil for everything from gas-guzzling cars to plastics.  And, to the point that I made earlier, this bout of inflation was finally reigned in when Fed Chairman Paul Volker dramatically raised interest rates and within three years brought inflation from over 13.5% down to around 3% annually. 
 
Circling back to the question at hand, are we facing increasing inflation or is it just transitory as many economists and the Federal Reserve seem to think.  Frankly, I believe that it is transitory.  We are already seeing the prices of many commodities that had soared in value coming back down to earth again.  We need only look to the futures markets to see this.  For example, lumber traded as low as $282.10 per 1,000 board feet in early-April 2020 during the pandemic, climbed as high as $1,733.50 in mid-May this year before falling back to $737.40 at the end of June.  We have seen similar moves in corn, wheat, copper, and most other commodities as well.  All these commodities are well off their recent highs set in mid-May.  If this is truly indicative of transitory inflation, the Fed is correct not to raise interest rates now as that could potentially choke off the recovery from the pandemic.  In fact, the Federal Reserve, in their most recent meeting, indicated they would most likely not be raising interest rates until 2023.  I am cautious on this expectation and would not be surprised to see a late-2022 rate hike.  I believe data may force them to move sooner than they want but, regardless, we still have at least a year of continued low interest rates fueling continued money flows into the stock market.  The key reason for this, as I have been saying for a while, is that this is a TINA world – as in ‘there is no alternative’ to stocks if you want to earn any return at all. 
 
All this fascination with inflation led to an interesting rotation in stocks for the quarter.  Many stocks that have been beneficiaries of the re-opening of the economy such as the airlines fell the hardest.  Stocks that gained for the quarter were heavily tilted to oil companies and industrial names, both of which tend to benefit from inflationary pressures.  I suspect the staying power of these oil and basic industrial stocks is as transitory as commodity prices have been.  Trying to time the markets by picking and choosing the ‘hot’ sector is a fool’s errand and something we avoid.  I prefer to find stocks that meet strict criteria and stick with them provided they continue to meet our standards for growth, quality, and potential long-term returns. 
 
We did a lot more trading this quarter than we normally like to do but most trades worked out in our favor.  During the quarter, we sold out of Beazer Homes USA (ticker: BZH) for a 23.73% gain, eliminated Cardinal Health, Inc. (ticker: CAH) with a small 4.17% gain, sold sporting goods retailer Hibbett, Inc. (ticker: HIBB) for a 53% gain, exited boating retailer MarineMax, Inc. (ticker: HZO) with a 60% profit and closed our position in construction firm Primoris Services Corp (ticker: PRIM) with a small 13% loss.  We sold either because the quality of the company had slipped in their recent earnings report, they were trading well above our estimate of a fair price, or their growth prospects were falling. 
 
On the flip side, we put some profits back to work, adding to our existing holdings in Atlas Air Worldwide (ticker: AAWW) as well as several new positions.  These new holdings include paper products company Clearwater Paper Corp. (ticker: CLW), two home décor stores, At Home Group (ticker: HOME) and Williams-Sonoma Inc. (ticker: WSM), apparel retailer Citi Trends, Inc. (ticker: CTRN) and RV dealer Camping World Holdings, Inc. (ticker: CWH). 
 
We also recognized that we had too much idle cash just sitting around collecting dust in many accounts.  Rather than let that continue to sit idle earning 0.01%, we bought an exchange-trade fund, the SPDR Bloomberg Barclays Investment Grade Floating Rate ETF (ticker: FLRN) that invests in short-term corporate bonds that have adjustable interest rates.  This will be beneficial when interest rates do finally start going up as the interest rates paid on these bonds will also increase resulting in higher dividend yields on this fund.  In the interim, the fund is paying a dividend of 0.21% on a “cash-like” investment.  It is important to note that this is not a guaranteed investment, and the value can and will change.  Typically speaking, the price of this fund will remain reasonably stable over the short-term.  This is not an investment in which we are looking for large capital gains.  We were looking for an investment that is reasonably safe, liquid, and earning something more than leaving the money in cash.  This fund fit that bill well. 
 
One last point on the cash management front.  One additional tool we have been using up until recently has been an options strategy called a “bull put spread” in client accounts.  This has often offered us a 10 – 11% return on the amount we were risking over the course of a month.  Basically, we were acting as an insurance company for people who thought the market might fall.  They might purchase insurance on their portfolios in the form of put options that would pay them cash if the market fell below a certain level.  We took the other side of that trade but to offset our risk, we would purchase insurance ourselves just a little bit lower in value.  For example, with the S&P 500 Index trading around 4,369, we might sell an option that obligates us to pay the holder if the index fell in value to 3,995 at expiration.  To offset this risk, we would turn around and purchase an option that would pay us if the index fell to 3,990, limiting our risk to the $5 difference between these two values or $500 in total.  To further mitigate risk, I typically limit the number of option contracts to only 1% of any individual’s account size, though some clients can afford to take a bit more risk.  This ensures that, even in the event of a market blowup, we won’t lose more than we can easily recover in a short time.  This strategy typically added over 2% or more to account performance over the first half of this year in those account where we have actively traded.  The key reason we have stopped doing this for now is that, with the complacency that seems to have settled over the markets, we cannot get enough premium to make this strategy worthwhile for now.  I am sure this will change again in time, and we will return to this strategy. 
 
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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