Client Letter 4Q 2023

For the past two years, I have been preaching to “listen to the Fed”.  The Federal Reserve, the governmental agency tasked with “maximum employment and price stability”, has been steadily raising interest rates over the past two years.  They last raised interest rates in July and then went on an expected pause to see how policy affected the high inflation rate they were attacking.  Surprisingly, even as interest rates rose dramatically, the pace of companies hiring slowed only marginally and has remained over 200,000 new jobs per month through the November jobs report.  This was in stark contrast to the widespread expectation for a recession following the dramatic interest rate hikes. 
 
The big story of this past quarter occurred in mid-December at the last Fed meeting of the year.  As was widely expected, the Fed held interest rates unchanged.  However, the two big surprises came from the notes to their two-day meeting and Jay Powell’s press conference at the end of the meeting.  In the notes, the Fed governors indicated they expected up to three interest rate cuts in 2024 which was a shock.  Many investors had assumed one or maybe two interest rate cuts with those coming later in the year.  I was in that camp, as the Fed has been consistently saying “higher for longer” meaning they want to keep interest rates at higher levels until the inflation rate returns to their 2% target range. 
 
In a bigger surprise – at least to me – Jay Powell stated in the press conference in response to a question about the timing of the rate cuts that he would expect to cut rates before inflation hits the 2% rate in order to not overshoot the target.  With inflation currently around the 3.1% level, this opens up the possibility of a first rate cut in the first half of the year.  With the probability of interest rate cuts on the horizon, this means a shift in investing.  As interest rates fall, small and midsized companies should do better.  Also, more growth-oriented companies such as tech companies should do better as interest rates fall. 
 
Given this Fed pivot, you can expect some changes to our investment lineup.  Some of the changes are already in place while others will be coming soon.  We have been watching a number of smaller and mid-sized companies as solid investment opportunities, but many of these stocks have seen a large run-up in price in recent weeks leading to them being “over bought” for now.  We would expect prices to correct a bit, as they have been doing in the past few days, giving us a better buying opportunity. 
 
In addition to adding more smaller and mid-sized companies to client portfolios, we will be moving to more growth-oriented mutual funds for clients as well as adjusting our fixed income (bond) holdings to take advantage of the potential rate cuts to come.  In finance-speak, we are going to extend the duration of our fixed income holdings.  To explain that in plain English, we will be selling bond funds that focus on short-term bonds and adding funds that hold bonds that mature further out in time.  This will take advantage of locking in these higher interest rates, and we should see some gains in value as interest rates fall, which will increase the value of the bonds in these funds. 
 
This past quarter, we made a few trades.  We bought a U.S. Treasury note when interest rates were very near their peak, locking in a 5.2% yield through the August 2025 maturity.  We also started adding a few selective smaller and mid-sized companies to client portfolios.  One company that we picked up at a very reasonable valuation is egg producer Cal Maine Foods Inc. (ticker: CALM) which is already up 14% for us.  Another small but growing company we added is Wabash National Corp. (ticker: WNC) which builds semi-trailers, truck bodies (think of box trucks) and processing equipment.  This is a classic industrial company that is in very good shape and growing at a nice rate. 
 
Just before year-end we added a new bond fund to client accounts.  We added the Janus Henderson Mortgage-Backed Securities ETF (ticker: JMBS) across most client accounts.  This fund invests in mortgage bonds and, more specifically, mortgages that are backed by governmental agencies such as Federal National Mortgage Association (“Fannie Mae”) or the Government National Mortgage Association (“Ginnie Mae”).  This government backing provides a level of stability to the bond holdings in the fund.  Another new investment is the Putnam BDC Income ETF (ticker: PBDC), which invests in business development companies (BDCs).  These are investment companies that primarily make loans to small but growing businesses that are not large enough to go public yet and need capital to grow.  Sometimes, these BDCs will also take an equity stake in these businesses.  These investments are a bit riskier, but often provide higher returns to investors. 
 
On the flip side, we sold our investment in online file storage company Dropbox Inc. (ticker: DBX) for a little more than a 15% gain in five months.  We also sold out of Expedia Group Inc. (ticker: EXPE) – too soon it seems – for a small 3% gain.  The financials seemed to be deteriorating so we chose to seek investments with a better margin of safety.  Another sale was the SPDR S&P Oil & Gas Exploration & Production ETF (ticker: XOP).  This had been doing well, but oil prices have been falling steadily since their late-September peak.  We managed to book about an 8% gain on this fund.  We also eliminated our holding in the WisdomTree Floating Rate Treasury ETF (ticker: USFR) as this was part of our shift from funds that focus on short-term bonds to ones that focus on longer-term bonds.
 
Overall, we had a productive quarter and a very productive year.  Client account returns were very good across the board.  While I am very pleased, I am working to improve client performance without taking additional risk.  By selectively using some option strategies, we should be able to continue to enhance client returns over time. 
 
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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