Client Letter 3Q 2020
This has been the longest month of March ever. Oh… wait…. It’s October now isn’t it which means another quarter has just ended. In many respects this was a normal quarter with not a lot of excitement. The market continued its relentless climb out of the depths of the recession in March peaking in early September at new all-time highs before sliding over the next three weeks in what, so far, has been a garden variety correction. Most investors consider a fall of around 10% to be a correction. The broad S&P 500 index fell 9.6% between September 2 at its peak and September 23 when it hit its lowest point.
If you recall last quarter’s letter, I mentioned that the S&P 500 Index is greatly influenced by a few large tech names such as Apple, Alphabet (Google) and Facebook. That continues to be the case. As evidence of this while the widely followed S&P 500 Index fell about 10% in September, the equal-weight version of the index only fell 8% for the same period. By contrast the very tech-heavy NASDAQ Index fell almost 12% over those three weeks. While some of the funds we hold across client accounts do tilt towards these large tech names we still did a good job of controlling risk. Across all accounts we were only down a little over 6% during this correction.
As interesting as these numbers are the one thing to keep in mind is that the stock market is not the economy. This is oftentimes difficult for many to understand. What is worse is when members of this administration, who should know better, continue to equate the stock market’s recovery with the economic recovery. This is simply not the case. Normally, the stock market will reflect expectations for the broad economy, but there are times when the two can become divorced from each other. This is likely one of those times. While the stock market oftentimes looks ahead and anticipates changes in the economy there are times when the market and reality can diverge. The stock market has essentially gone through a “V” shaped correction and recovery. We had the economy essentially shut down in March as the coronavirus pandemic hit us. Stock prices and stock index averages plunged. However, as soon as stimulus money started pouring into the financial system the stock market turned and headed north again. Even discounting the recent 10% correction – not an unreasonable expectation given the 60% rise from the bottom in March to the most recent new high in September – the stock market is well ahead of the overall economy in terms of recovery.
To put the economy in context, at the height of the great recession, unemployment hit a peak of 10.0% in October 2009 with 15.7 million people out of a job. This past April, when the pandemic closed our economy, the unemployment rate hit its highest point in recorded history at 14.7% as 23.1 million people were out of work. As stimulus money designed to keep people employed started flowing and states began gradually reopening, the unemployment rate started falling. By September, the number of unemployed had fallen to just under 13 million. This is the point where the stock market and the economy seem to diverge. The stock market seems to be pricing in a continued recovery and a continued reduction in the unemployment rate. While I am confident we will recover from this pandemic, I am so sanguine on the rapidity of that recovery. I would argue that things are likely to get worse before they get better, especially in light of recent news and events. Please allow me to explain.
One of the key stimulus items that helped reduce the unemployment rate was the PPP or paycheck protection plan loan program. Companies were able to borrow money from the government at a favorable interest rate. If the loan was used strictly for payroll to keep employees on the books or rehire those that had been furloughed and the employees were still there at the end of September, the loans would be forgiven. We are now past the end of September and companies are having loans forgiven but business has not necessarily picked up yet. This is leading to layoffs again.
In fact, we have seen quite a number of announcements of coming corporate layoffs in the past few weeks. Disney announced a 28,000 reduction in their workforce. Cineworld, the owner of Regal Theaters, has closed all their theaters in the U.S. and the U.K., laying off about 40,000 workers here. MGM Resorts is cutting 18,000 workers. Kohl’s is cutting 15% of their workforce as more shoppers move to buying on-line. The beleaguered airline industry has announced that 32,000 or more employees may be let go and Southwest Airlines, in an attempt to keep from having to lay off anyone, is negotiating to cut salaries of all employees 10% across the board. These are a few of the largest companies and speak nothing of the small Mom and Pop restaurants, bars, and retailers that are closing every day. The online review company, Yelp Inc. has data to show that between March 1 and July 25, more than 80,000 business permanently shuttered.
If you recall I mentioned that I was not terribly worried about a major stock market meltdown because I was confident the Federal Reserve would step up with some sort of stimulus package to provide a floor if possible. I still believe that to be true but there is a limited amount the Federal Reserve can do to deal with more structural issues such as all these layoffs. In recent testimony before Congress, Fed Chair Jay Powell called on Congress to provide more stimulus money to help ease the burdens. Chair Powell essentially said that even if Congress spent too much money on stimulus it would not be wasted as it would contribute to a faster recovery. I tend to agree with Chair Powell. I am not a fan of wracking up deficits that we never pay back. I have long said that I am a diehard Keynesian when it comes to economics. As such, I believe we need to spend during times of crisis even if it means borrowing to do so. However, I believe that once we recover from this pandemic – and we will recover – we need to pay these debts back and run a balanced budget.
In addition to the threat of massive layoffs, for many people unemployment benefits fell dramatically as of the end of July. As part of the stimulus package passed in March unemployment benefits included an extra $600 per week. This expired at the end of July. The President did issue an Executive Order that temporarily extended additional unemployment benefits at a reduced rate but that money was taken from the FEMA budget – the funds that are typically used for Federal emergencies such as hurricane relief – and those funds dried up by late August. Add to this the high probability that many businesses may have to close down again as winter comes on and coronavirus cases almost inevitably surge again and there is a compelling argument for additional stimulus money to get us through this pandemic. However, the Republicans in the Senate seem loathe to want to do anything more, counting on the money they have already spent to be enough. Further confusing the situation, you have a President who changes his mind on whether to go through with a stimulus package seemingly by the minute. On October 3, the President tweeted to the Republicans that he wanted a stimulus deal. By mid-afternoon on October 6, he tweeted out that he was no longer going to negotiate on stimulus. The stock market quickly lost about 600 points to close down for the day. Now, it seems stimulus is back on the agenda as the President has announced that he is willing to come close to the $2.2 trillion package the Democrats in the House passed recently. Whether or not the Senate is willing to take this up before the election remains to be seen.
The bottom line is that without additional stimulus funds, any recovery is going to be glacial at best. In fact, if we don’t get any additional stimulus given the number of potential layoffs and the greatly reduced unemployment benefits the recovery could turn south again. This is likely to give us what some had feared would be a “W” type of recession. That is the economy fell dramatically in March. We had a gradual recovery through September but now we take another sharp leg down before finally turning back up as the coronavirus eventually is brought under control next year. Additional stimulus could get us over the hump of the winter and into the spring when businesses can again focus on reopening and we will hopefully have a viable vaccine coming available. It could help prevent that second leg down of the “W” which would benefit everyone. I am paying close attention to what happens in Congress so we don’t get caught in a second sell-off should that happen.
With all of that out of my system, how did we do this past quarter? By most measures this was a good quarter for us. We added a several new positions this quarter. We have been very selective in our purchases sticking with quality companies that are showing solid revenue growth and high free cash flow. New names to client portfolios include Great Lakes Dredge & Dock (ticker: GLDD), recreational boat retailer MarineMax Inc. (ticker: HZO), homebuilder Lennar Corp. (ticker: LEN), semiconductor equipment company Photronics Inc, (ticker: PLAB), grocery distributor SpartanNash Co. (ticker: SPTN) and homebuilder TRI Pointe Group Inc (ticker: TPH).
In many accounts rather than buying shares of the stocks we liked directly we instead chose to use options strategically. We sold put options which obligated our clients to buy these underlying stocks. For example, in August we sold an option that obligated our clients to buy 100 shares of Great Lakes Dredge & Dock for $9 per share. We collected $29.33 for taking on this obligation. Our total risk was $900 should we have to purchase this stock even if it was priced at zero. The premium we earned may not sound like a lot, but that equates to earning 3.26% in a month and a half. We were able to repeat this process again earning a little bit more the second time. We will continue this strategy as long as we are able to earn good premiums. In the current market environment of volatility and uncertainty, selling (writing) options has proven to be very profitable. In this quarter alone, we have earned 3.3% and 3.4% from options on Great Lakes Dredge & Dock, 4% on options on Lennar, 6% on Photronics options, 6.2% on SpartanNash options, 9.5% on Weis Markets options and a healthy 12.4% on TRI Pointe options. I would like to believe we can continue this strategy indefinitely, but the reality is that, at some point, there will be less uncertainty and we will revert to simply buying and holding good stocks. This does not mean we are stopping this strategy. It simply means we probably will not have as many lucrative opportunities.
On the sell side, we eliminated our holding in Canadian insurance giant Manulife Financial Corp. (ticker: MFC) taking a small loss in the process. This investment was starting to become too risky. The Parker Drilling (ticker: PKDC) that we held in several client accounts was finally bought back by the company at $30 per share. This gave us a tremendous return for the quarter since the stock was selling for around $6 per share at the end of June. Based on our $20.50 original cost, it was worth waiting for the nifty 46% return on that investment. We remain pleased with the mutual fund lineup we have in place now and are merely “tweaking” client allocations to deal with this success. The Virstus KAR Mid-Cap Growth fund that we started buying in early-April around $37 per share closed the quarter at $58 per share for a 55% gain. We have been trimming a little bit in client accounts to reduce the amount of risk we are taking with this fund though it remains a great fund and a key allocation for clients.
What can we expect for the rest of the year? With a potentially contentious election process already signaled we can expect continued volatility. Regardless of who wins the election stocks will continue to do well. Certain sectors will do well under a continuing Trump administration while different sectors would benefit from a Biden election. In fact, as long as the Federal Reserve continues to provide stimulus money by continuing to buy bonds this money will continue to flow into the stock market. If we do not get any fiscal stimulus from Congress before the election, we will likely remain in a narrow trading range. Clarity on the election results will dictate the direction of the markets in the short term. Over the long term I continue to be optimistic.
As you know the coronavirus is still a major issue. Cases are rising in many states so there is still a significant risk. The recent “super spreader” event at the White House which led to most of the senior staff being infected shows just how vulnerable we still are as a nation. I will again not be traveling to see clients this quarter. However, that does not mean we cannot meet face-to-face. I mentioned last quarter that I have added GoToMeeting, a video conferencing software, to my repertoire. If you would like to schedule a meeting with me, please feel free to either email me or call me and I will set this up and send you the invite to the meeting. 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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