Client Letter 2Q 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.
Alan R. Myers, CFA
President / Senior Portfolio Manager
Aerie Capital Management, LLC
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