Client Letter 4Q 2021

Another quarter and year have ended.  If we had to sum up the year in one word, it might be “inflation”.  Inflation seemed to be on everyone’s mind for most of the year.  We debated whether it was “transitory” or not, whether President Biden could reign it in (hint:  Presidents have very little control over the economy, especially in their first year in office), and whether we were headed for that old 1970’s hit, stagflation or not.  As I looked back at quarterly letters I sent this past year, I was pleasantly surprised at how prescient I was about things.  Of course, that is part of my job – to be able to read the tea leaves of the economy so I can better position us for what may come. 
 
I will reiterate what I said last quarter.  This world is often random and chaotic and only makes sense in retrospect.  Proof of this is in the stock market.  On the next-to-last trading day of the year, the market as measured by the S&P 500 index notched its 70th record high close for the year.  On the last trading day of the year, the index was in new record territory until literally the last 14 minutes of the day, when it fell 0.26% for the day.  Did anything of significance happen to cause this?  Likely, it was simply investors trying to lock in gains exacerbated by low trading volume.  In other words, there were not a lot of investors trading which created more risk and wider moves in stock prices.  As investors sold, the lack of buyers allowed prices to fall.
 
While many random events can occur, putting a frame around what could or is likely to happen helps.  The problem is always the unknowns that we don’t know but we can speculate on the things we do know.  We do know the Federal Reserve is tapering their bond buying.  Since the start of the pandemic, the Federal Reserve has been buying bonds from the public.  This has the effect of putting more cash into our financial system (the Fed pays cash for the bonds they buy).  The Federal Reserve owned about $4.2 trillion in bonds just prior to the pandemic shutdown at the end of February 2020 and today has about $8.8 trillion in bonds.  This means the Fed has added $4.6 trillion in cash to our financial system.  This cash had to go somewhere, and much of it likely ended up in the stock market.  In fact, this cash accounts for about a third of the growth in the value of the U.S. stock market over the period from the end of 2019 through the third quarter of 2021. 
 
Does this lack of further cash infusions have any implications for us as investors?  I believe we are likely to see more volatility, larger pullbacks, and longer recovery times from these corrections.  Investor sentiment lately has been to “buy the dip”.  This has proven to be a winning strategy keeping drops in the market relatively shallow essentially since the Great Recession.  Even with the large drawdown during the pandemic last year, the market recovered amazingly quickly.  The only other significant drawdown occurred in November and December 2018 when the Federal Reserve was raising interest rates during a serious trade dispute with China.  This all combined to make investors very nervous.  Since there was no end in sight to the potential problems, investors could not figure out when to buy.  The turning point was when Fed Chair Jay Powell capitulated and reversed course on more rate hikes the following year. 
 
I suspect we are going to see more volatility this year, and at least one pullback of more than 10% in the market.  I want to be clear that I am not advocating for selling and going to cash.  Quite the contrary.  I think any pullback of 10% or more will create some good buying opportunities.  I am more likely to sell into strength, so we have some cash sitting on the sidelines for these potential market fluctuations. 
 
We also know the Federal Reserve is going to raise interest rates.  Jay Powell has told us so and the Fed really needs to keep inflation in check.  The market is anticipating at least three rate hikes over this next year.  The first one is not likely to occur until the Fed ends their quantitative easing (bond buying) which is likely to occur by March.  If the Fed sticks to the script, we will probably see the first interest rate hike by June.  What could turn the markets on its head is if we get a larger than expected hike or if we get more than three hikes this year. 
 
The biggest change we are likely to see is in the types of stocks that lead the market.  As interest rates increase, this will make the high growth stocks that have been the market leaders over the past few years less attractive.  We have already started seeing this changeover in leadership.  When you look at the best performing stocks for 2021, the top of the list is littered with oil companies and basic industries like Devon Energy, Marathon Oil, Old Dominion Freight Line and fertilizer company CF Industries.  We have already started seeing a shift in companies fitting our criteria that align with this shift in focus.  If you recall, in the third quarter of the year we added timberland REIT PotlacthDeltic Corp (ticker: PCH) which we purchased back in August.  This quarter, we added shipping company Matson Inc. (ticker: MATX) in early December.  We also added shares of Hillenbrand Inc. (ticker: HI), an industrial company that is probably more famous for starting life as Bates Casket Company which they still own.  We are starting to see more signs of “value” stocks in our lists and expect this trend to continue over time. 
 
The two biggest questions – and the biggest unknown – is how quickly interest rates will rise and how far.  The latter answer depends upon your view of inflation.  Many have been in the “transitory” camp meaning they think the high inflation rate we are seeing will resolve itself as Covid fades and the supply chain fixes itself.  If this is the case, interest rates will not rise significantly.  Others are not so sanguine on this scenario.  I have been gradually moving from the former camp to the latter though I am not worried about a permanent high inflation rate as are some pundits.  I see some things – higher wages required to entice people back to work and a permanent labor shortage due to a lack of people with the necessary skills – that will drive higher prices for a long time to come.  This pandemic has sped up some trends that were inevitably coming.  I think we will end up with a semi-permanent modestly higher inflation rate than we have been used to over the past decade.  In other words, a return to normal.  I would not be surprised to see interest rates top out around 4 – 5% annually on a 10-year Treasury bond.  The yield on this bond has been the measure everyone is paying attention to currently.  As I write this, the bond is paying about 1.66% annually.
 
The toughest part of navigating the inflation and rising interest rates issue is balancing off stocks versus bonds.  I have been saying for a number of years that we are in a “TINA” world – there is no alternative to investing in stocks.  That will change as interest rates rise.  At some point, bonds will be a viable investment alternative.  In the interim, bond investments are merely a place to park cash and a bit of an anchor for a portfolio.  We recently made a small change in the fixed income allocation in client accounts.  We eliminated the SPDR Bloomberg Investment Grade Floating Rate ETF (ticker: FLRN) in favor of the Janus Henderson AAA CLO ETF (ticker: JAAA).  This fund invests in debt instruments called “collateralized loan obligations”.  These are large, first-lien senior corporate loans.  These loans have adjustable interest rates which means that as prevailing interest rates in the economy rise, so does the interest paid on these loans.  The loans this Janus fund holds tend to be very high quality, yet the fund offers a much better dividend yield than the SPDR fund we held without compromising safety. 
 
After many months of intensive research, I have finally found a “go anywhere” bond fund that I think will provide the safety our clients need and deserve without compromising returns.  You can expect to see the T. Rowe Price Total Return fund showing up in accounts soon.  This fund had the singular distinction of having a positive return last year when most other broadly diversified bond funds did not.  So with the addition of the Janus Henderson fund to help us in a rising interest rate environment and as a place to “park cash” and the soon-to-be-added T. Rowe Price broadly diversified fund, we have the fixed income piece of the puzzle covered for client accounts. 
 
Hopefully, despite my expectations for increased volatility, we can settle down to a more comfortable buy-and-hold strategy versus the amount of trading we did over the past year.  While this trading did play out in our favor for the most part, I am just not a big fan of trading too much.  During the fourth quarter, we eliminated several stocks including Clearwater Paper earning between a 10% and 20% return, Camping World Holdings with a small loss, Quest Diagnostics for a small 5% profit and Williams-Sonoma with gains between 35% and 40% on our investment.  We also cut back on the Virtus KAR Mid-Cap Growth fund due to the level of risk in that fund and its holdings.  Upon further review, we will likely eliminate this fund from the lineup this year.  Thankfully we have one or two other funds already in client accounts that can take up where this fund left off.
 
We did add a few new positions this quarter.  I mentioned earlier adding shares of shipping company Matson and industrial company Hillenbrand.  We also added shares of chicken producer Sanderson Farms Inc. (ticker: SAFM) which is in the process of being acquired.  There is some risk from the new Biden administration that the acquisition will not go through which gave us the opportunity to acquire the shares at a discount.  Should the merger be completed, we will earn a 7% return in a reasonably short period of time.  If the merger is not consummated, Sanderson Farms still represents a great bargain at the price we paid so this is a win-win either way. 
 
Finally, towards the end November, we dipped our toes into the EV, or electronic vehicle, space by obligating clients to purchase shares of Ford for $17 per share.  We wrote (sold) a put option and collected a premium for this obligation that is paying us a 2.76% return over the 52 days the obligation is outstanding.  Likely, this option will expire worthless, and we will simply write (sell) another put option to again collect more premium.  Part of the reason for doing this is that I really think the price we are seeking to pay is a fair price.  Ford currently makes one of the most popular vehicles of all time, the Ford F-150 pickup truck.  They have now introduced an EV version of this truck that has proven so popular, they are having to double production in the first year of manufacture.  This type of news has caused the stock to pop to a value that is, in my opinion, excessive and I refuse to chase this stock or pay too much just to gain access to what is a “hot” sector of the market currently.  I would rather be patient and continue to collect premiums and let the stock come back to us.  As I mentioned earlier, I fully expect more volatility and at least one larger pullback this year and I think we will be able to get shares of Ford at that point at a fair price. 
 
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