Market Commentary

In the 1967 movie The Graduate, Dustin Hoffman’s character Benjamin is taken aside by a family friend at his graduation party and is told that he has one word of advice for him: “plastics.” While S&P returns in Q2 were primarily driven by a narrow set of stocks that benefit from a new technology spending cycle driven by artificial intelligence or AI, Q3 returns were driven by cyclical industries, including chemical companies that manufacture plastic. During the third quarter, the S&P 500® Index returned 5.5%, but unlike in Q2, the Equal-weighted S&P 500® outperformed its market cap-weighted brethren by returning 9.1% as the market broadened. The Magnificent 7 had mixed returns for the quarter as investors reallocated dollars into traditional cyclical sectors as expectations for Fed rate cuts increased. Inflation, as measured by the CPI for August, decelerated to 2.5% year-over-year, the smallest increase since February 2021. Following weakening employment numbers and moderating inflation, the Fed initiated a rate cut program by cutting its Federal Funds rate by 50 basis points (bp) to 4.75% to 5.0%. The yield curve, which became inverted in 2022, steepened with the 2/10 Treasury curve, ending the quarter at +15 bp.

The market set all-time highs in July before experiencing a pullback following weaker than expected non-farm payroll numbers in July. The Federal Reserve’s language became more dovish leading up to Powell’s speech in Jackson Hole in August, where the Fed Chairman signaled that the Fed’s policy would become more accommodative. The increased likelihood for rate cuts led to outperformance for traditional cyclical and higher yielding sectors, including Utilities (+18.5%), Real Estate (+16.3%), Industrials (+11.2%), Financials (+ 10.2%), and Materials (+9.2%). Many of the Magnificent Seven, which as a group outperformed the S&P 500® by 1100 bp in the second quarter, were down in the third quarter including Google which was down 9.0% (2.2% of portfolio value), Microsoft which was down 3.8% (4.9%), Amazon which was down 3.6% (3.7%) and Nvidia which was down 1.7% (3.9%). As a result, the Technology Sector and Communication Services were two of the worst-performing sectors, each up only 1.4% versus 5.5% for the S&P. Energy (-3.1%) was the worst-performing sector as global GDP growth concerns, particularly in China and increased production negatively impacted oil prices with WTI prices dropping 16.4% in Q3. Following the broadening of the market in Q3, we believe the market rally could continue if inflation continues to moderate.

Portfolio Equity Positioning

Consistent with our 2^nd quarter outlook for broadening participation in the year's second half, we focused on increasing portfolio exposure within cyclical recovery themes, such as housing, while maintaining our secular growth exposure (technology) for further appreciation into 2025. Stanley Black and Decker (SWK 1.9% of portfolio value) provides hand and power tools utilized in housing construction and do-it-yourself home projects. The company raised guidance for the full year and increased free cash flow and gross margin projections by focusing on better capital management and supply chain efficiencies. Organic growth also inflected positively as demand strengthened for the DeWalt brand even in a challenging macro housing environment. Broadcom (AVGO 2.0%) designs, develops, and supplies semiconductor and software solutions for AI, wireless, and enterprise applications. The company reported significant year-over-year revenue growth of 47% in the fiscal third quarter of 2024, driven by growth in AI revenue, accelerated bookings in VMware, and stabilization in non-AI (cyclical) semiconductor revenue. Prologis (PLD 2.0%) was purchased after reporting a 27% increase in leasing activity with significant rent change performance, up 70%, for its portfolio of industrial leased properties. With a 96.5% occupancy rate, the company was able to lift its guidance for fiscal 2024 and 2025 with strong momentum in its data center business, which is expected to contribute substantially to its growth.In addition to new purchases, we added to existing positions, including Dupont (DD 2.4%), Meta (META 2.7%), and Tyler (TYL 1.5%). Dupont exceeded guidance, mostly driven by a strong recovery in its electronics unit, which saw significant growth with its AI applications and new wins in the consumer electronics market resulting in guidance being raised for the full year 2024. Meta was weighted up while Alphabet (GOOGL 2.8%) was trimmed due to Meta’s ability to monetize its AI applications across a swath of services, which is driving strong user engagement and user growth. Meta saw a 22% increase in total revenues with a solid 38% operating margin. Tyler continues to execute admirably as it recorded its 14^th consecutive quarter of over 20% growth driven by the growing acceptance within the public sector to migrate to the cloud, where clients can better utilize Tyler’s SaaS services versus legacy systems.

Purchases were funded with the sales proceeds from Pepsi (PEP 1.5%), Honeywell (HON 1.3%), Emerson (EMR 1.8%), and Hershey (HSY 0.80%). We exited Pepsi due to concerns about pricing power within the Frito-Lay snacks division and the effects of trade down from an increasingly budget-conscious consumer, especially within the domestic market. Honeywell was sold due to the difficult environment within the short-cycle product portfolio, which led to effects on margins from mix impacts vs long-cycle products. Emerson was sold due to the drag on performance from its National Instruments Corp acquisition and generally better opportunities elsewhere within the industrial sector. Hershey was sold due to concerns around pricing and strategic initiatives to grow revenue and check cost pressures. In addition, the company has been experiencing market share losses in core chocolate.  

Other funding sources for purchases were realized from partially called-away positions, including Eli Lilly (LLY 2.9%), Coca-Cola (KO 1.7%), Oracle (ORCL 2.6%), RTX (RTX 2.6%), and Welltower (WELL 2.0%). Several positions were reestablished at full weight as opportunities presented themselves within the quarter. These included Eli Lilly and Coca-Cola.

Call Option Premium

As investors priced in aggressive rate cuts and vacillated on the severity of an economic landing, volatility levels ebbed and surged in August and September. Worries mounted after July nonfarm payrolls printed well below consensus, giving the bears ammunition to argue for a hard landing and recession. In response, volatility levels briefly surged, topping 65 from relatively benign levels in the mid-teens as the market retraced 8% of performance in the first week of August. However, the volatility spike was short-lived, as weekly initial jobless claims stabilized and solid retail sales reports helped reassure markets that the consumer was still active. For the most part, the rest of the quarter saw volatility levels trade in the mid-teens. Throughout this period, premium income generation from new writes was roughly consistent with past quarters at 1.2% (4.7% annualized). The decision is made for each equity and corresponding call option position to either maximize income potential or seek additional upside participation with lower but solid income generation by writing further out in time but with a higher strike price. In this quarter, given the solid performance overall of the market and our equities, we chose to use some of the premium generation to roll existing strikes out on the timeline and to higher strike prices in order to drive total return from equity appreciation. For the quarter, the net premium generated after rolls was 1.1% (4.4% annualized), while the average days to maturity of the call options at initiation was 96 days, with 11.4% upside to strike prices, and the portfolio average percentage written was 55%.

Protective Put Positioning

The notional value of put contracts ranged from 15% to 50% of total portfolio value, ending the quarter at 15%. With the market pullback in early August, we were able to monetize a portion of the protective put contracts, netting a positive 19 basis points of return. As the market recovered into and through September, volatility levels subsided, giving us the opportunity to possibly raise the notional value of put protection to roughly 30% of the portfolio into the 4th quarter.  

Outlook

While the S&P 500® is up 20.8% through September, we see potential for the market to participate in further upside in the fourth quarter if inflation continues to moderate and the Fed rate cut cycle continues. We believe that the key to further upside is earnings growth (versus multiple valuation expansion), which could continue to surprise to the upside if earnings from cyclical stocks improve. We believe that Technology companies could do well in the fourth quarter, particularly those that can utilize AI to drive additional revenue growth and reduce costs. The Consumer Discretionary , Industrials, and Financial sector, could continue to perform well in the fourth quarter if the likelihood for a soft landing remains high. We continue to manage a barbell portfolio of both secular growers and value-oriented cyclicals. We remain diligent in our search for under-appreciated growth and value stocks and will trim positions that appear extended as well as add to positions on retracements.

IMPORTANT INFORMATION:   

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.  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.  [17812948-UFD-01/22/2024]

This information is for use with concurrent or prior delivery of a fund prospectus. Investors should consider the investment objective, risks, charges, and expenses of the Fund(s) before investing.  The prospectus and the summary prospectus contain 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.

This material is being provided for informational purposes only. Any information should not be deemed a recommendation to buy, hold or sell any security. Certain information has been obtained from third-party sources we consider reliable, but we do not guarantee that such information is accurate or complete. This report is not a complete description of the securities, markets, or developments referred to in this material and does not include all available data necessary for making an investment decision. Prior to making an investment decision, please consult with your financial advisor about your individual situation. Investing involves risk and you may incur a profit or loss regardless of strategy selected. There is no guarantee that the statements, opinions, or forecasts provided herein will prove to be correct. Opinions are subject to change without notice.

Definitions

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.

Call option:  A call option is a financial contract that gives the buyer the right, but not the obligation, to purchase a specific asset at a predetermined price within a specific time period. 

Covered call: Selling a call option on an underlying long-held security.

Notional:  In derivatives markets, such as futures and options, the notional value is the value of the underlying asset that the contract is based on.

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.

Put protection:  Implementing a protective put by purchasing a put option vs a long underlying equity position or broad index that is not necessarily held.   

S&P 500® Index:  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.

Strike Price:  The predetermined price at which a specific security may be purchased (for a call option) or sold (for a put option) by the option holder until the expiration date of the options contract.

VIX Index:  The ticker symbol and the popular name for the Chicago Board Options Exchange's CBOE Volatility Index, a popular measure of the stock market's expectation of volatility based on S&P 500 index options.

Volatility: A statistical measure of dispersion of returns.

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