Client Letter 3Q 2021
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.
Alan R. Myers, CFA
President / Senior Portfolio Manager
Aerie Capital Management, LLC
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