2022 Q4 Quarterly Commentary
by Robert Cagliola, CFA and Robert Hahn, CFA, on Jan 19, 2023 2:16:28 PM
To say the least, 2022 has been a very challenging year in many respects. For the markets, the benign investing environment quickly changed from one characterized by exceptional liquidity provided by the Federal Reserve’s easing policies and governmental stimulus initiatives to a market overwhelmed with concerns of high inflation, high valuations and downward earnings revisions. As a result, we saw one of the fastest multiple deratings in many years. Entering 2022, the S&P 500 traded at 21.5x forward 12-month earnings, while the 10-year U.S. Treasury note yield was 1.5%. In addition, the Fed was still buying a combination of roughly $60 billion of Treasury and agency mortgage-backed securities while the Fed Funds rate target range was at 0.00-.25%. The Fed’s personal consumption expenditures (PCE) inflation projection was a meager 2.6% for 2022.
What changed? Coming out of the March 2020 lows, investors had large unrealized embedded gains and a desire to cash them in. As the New Year kicked off, immediate selling began as investors foresaw the coming realities that would irritate equity markets. The Fed was about to announce an end to quantitative easing with a new Principles for Reducing the Size of the Federal Reserve’s Balance Sheet report. Investors were further agitated by Russia’s impending invasion of Ukraine and the implications it would have to the myriad of commodities produced in that region. Ukraine accounts for 10% of the world wheat market, 15% of the corn market, and 13% of the barley market. In addition, fertilizers and oil seeds are significant exports as well. As the Russian troop presence on the border increased, so did the prices of these commodities. Oil markets responded in kind as US and EU sanctions got going and the realities of accelerating food and energy inflation began to come into view. The yield curve began to flatten and eventually invert and steepen further into the year. A hard rotation out of growth/tech and into value/cyclical equities commenced and accelerated for most of the year, with brief respites in March and July. Investors’ focus shifted to quality equities, or those that produced cashflow and maintained pricing power with strong balance sheets to support their businesses and also boost stock buybacks. The writing was on the wall for speculative, easy liquidity-driven long duration assets that would struggle in a rising rate environment with little hope for near-term profitability.
As the year progressed, a struggle ensued between markets and the Fed, with investors’ rationalizations around the Fed’s resolve and commitment to hiking interest rates in an attempt to quell inflation. In March, investors convinced themselves of the benign side of the argument that inflation would peak shortly. Therefore, the Fed would slow rate hikes and eventually ease by year-end or shortly thereafter. What they were met with was Jerome Powell’s post-FOMC meeting press conference, where he went on to say, “we need to see inflation coming down in a clear and convincing way.” He added, “We’re going to keep pushing until we see that. If that involves moving past broadly understood levels of ‘neutral,’ we won’t hesitate at all to do that.” This movie played again in the summer months after the markets rallied 17% from June lows into August until Powell spoke at the Jackson Hole conference, where he was particularly hawkish with his comment that Fed policies would inflict “some pain to households and businesses” which clearly spooked investors. With that said, investors were correct in their thinking that inflation would peak and retrace as CPI numbers have receded from 9.1% in June to 7.1% in November and continue to trend downward. Energy and food costs have moderated and receded on recession fears, China lockdowns, and supply chain improvements. With fed funds futures estimating a terminal rate of 5.0%, it would suggest that rate increases should end shortly with current target rates at 4.25-4.50%.
Positioning and Returns
The Connors Hedged Equity Fund returned -1.4% for the fiscal year ended November 30, 2022, compared to -8.7% for the S&P 500®® Index and -8.4% for the CBOE S&P 500 BuyWrite Index (BXMSM). Given the concerns noted previously, the fund was initiated with a defensive posture upon start up on January 19, 2022 and continued to hold this exposure throughout the year. The Healthcare and Consumer Staples sectors were the top defensively overweighted sectors with Technology, Communication Services and Consumer Discretionary sectors significantly underweighted relative to the S&P 500® Index benchmark. Significant emphasis with fund holdings is placed on reasonable valuations, consistent and growing profitability, and increasing cash flow generation. Many stocks with these criteria can be found in the healthcare sector. Eli Lilly is one of the funds top performing holdings with an impressively diversified lineup of successful drugs and a solid pipeline. With well-positioned products like Mounjaro for diabetes with a rapidly broadening application (weight loss), the company can continue to drive doubledigit top and bottom-line returns well into 2023 and beyond. Other top performers in various sectors included Chevron and Schlumberger (significant return of capital), John Deere (growing preference for precision farming), Raytheon (rejuvenation of aeronautics and defense spending overseas), Costco (consistent and growing earnings with inelastic demand), Chubb (consistent earnings with yield curve tailwind) and TJX Companies (taking advantage of prime retailers’ inventory issues). Underperforming holdings include Qualcomm, suffering from a difficult handset environment but well on its way to diversifying its product offerings with growth in IOT and automotive. The company currently trades at a discount with a 2.8% yield that grew by 8.9% this year. Others include Disney (difficulty with streaming profitability), Amazon (suffering from slowing cloud growth but has many cost-saving levers to pull), Google (slowing ad revenues).
|The performance data quoted represents past performance. Past performance does not guarantee future results. The investment return and principal value of an investment will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance may be lower or higher than the performance data quoted. For performance current to the most recent month end, please call 833-601-2676.|
Call Premium Generation
Market volatility, as measured by the VIX Index, held significantly above 20 for just about the
entire year, even moving above 30 at seven different points of market disruptions throughout the
year. Fed tightening policy around inflation concerns was the main driver with intermittent jolts
from geopolitical events, hurricanes, and energy policy concerns. Call premium proved to be
exceptionally good in this environment as many simple returns exceeded 2% on 30-delta calls as
close as 60 days to maturity. Premium capture levels varied across sectors but were most
rewarding on technology holdings that experienced significant levels of volatility throughout the
year. Solid simple returns of 1.5% were even had for holdings that generally trade at lower
volatility levels. For every position, the decision is made to maximize return by grabbing income
through option writes or allowing for more upside participation with less option premium. For
the greater part of the year, given the market volatility, fund managers chose to write shorter
term at 60 days where possible at the 30-delta level during market spikes and drop to 20-delta
(higher relative strike prices vs. 30-delta calls but with lower premium return) during and after
market pullbacks. Total premium generated with call option sales was 4.3% through fiscal yearend
on November 30, 2022. This equates to 4.8% on a full-year annualized basis.
Downside Put Protection
Throughout the year, put spreads were implemented to varying degrees ranging from 20% to 50% of portfolio notional value. The tactical application of spreads is based on market technical readings and general trading ranges moving to support and resistance levels. The total additive return from this application was 1.4% through the fiscal year-end on November 30, 2022.
“Déjà vu all over again”. The renowned quote from Yogi Berra perhaps best sums up our view on the upcoming year. We expect current volatility will persist in 2023 as the Federal Reserve continues to focus on fighting inflation to get it back to its long-term target rate of 2%. Our expectation is that they will continue to raise rates at the next several Fed meetings, albeit by smaller increments (i.e. 25 bp) followed by a pause in rate hikes. While inflation, as measured by the CPI (Consumer Price Index), has declined from its June peak of 9.1% to 7.1%, we are likely to see inflation further subside as the cumulative impact of rate hikes and quantitative tightening take hold but this will also lead to declining US GDP growth (0.3% est. for 2023) and higher unemployment in the new year. There is also some debate as to how long inflation will remain elevated. The proverbial billion-dollar question is whether the economy slips into a recession and, if so, will the Fed reverse and possibly cut rates later in the year?
Whether or not we experience a technical recession, we expect volatility to remain elevated and
have positioned the portfolio accordingly. Consensus S&P earnings estimates for 2023 are likely
to come down, and we expect guidance to be conservative in the upcoming Q4 earnings calls. We
anticipate remaining overweight defensive sectors such as Consumer Staples and Healthcare and
will look for opportunities to add additional yield to the portfolio. We believe companies with
reasonable valuations, strong cash flow, and growing dividends will outperform. Greater volatility should enable us to collect attractive option premiums. We look for opportunities to upgrade our
portfolio and could potentially become less defensive if/when we foresee improving market conditions.
This information is for use with concurrent or prior delivery of a fund prospectus. Investors should consider the investment objective, risks, and charges and expenses of the Fund(s) before investing. The prospectus and, the summary prospectus, contains this and other information about the Fund and should be read carefully before investing. The prospectus may be obtained by calling 844-ACFUNDS (844-223-8637)
The performance data quoted represents past performance. Past performance does not guarantee future results. The investment return and principal value of an investment will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance may be lower or higher than the performance data quoted. For performance current to the most recent month end, please call 833-601-2676.
Past performance is no guarantee of future results. As with any mutual fund investment, there is a risk that you could lose money by investing in the Fund.
Out of the money: Out of the money refers to a call option with a strike price that is higher than the market price of the underlying asset, or a put option with a strike price that is lower than the market price of the underlying asset.
Investments in options involve risks different from, or possibly greater than, the risks associated with investing directly in the underlying securities.
Delta: The amount option is expected to move for $1 change in stock price.
The S&P 500® Index is a market capitalization-weighted index of 500 widely held stocks often used as a proxy for the stock market. Unlike mutual funds, the index does not incur expenses. If expenses were deducted, the actual returns of this index would be lower.
The CBOE S&P 500 BuyWrite Index (BXM) is a passive total return index based on (1) buying an S&P 500 stock index portfolio, and (2) "writing" (or selling) the near-term S&P 500 Index (SPX) "covered" call option, generally on the third Friday of each month. An investor cannot invest in an index and index returns are not indicative of the performance of any specific investment.
The Connors Hedged Equity Fund is distributed by Ultimus Fund Distributors, LLC. (Member FINRA) Connors Investor Services and Ultimus Fund Distributors, LLC are separate and unaffiliated.
Downside Put Protection: Put options increase in value when the underlying asset value falls. The Connors Hedged Equity Fund typically utilizes put options against the S&P 500 Index to help with risk mitigation and preservation of portfolio asset value.