Market Commentary
In Like a Lion, Out Like a Lamb
This well-known proverb is traditionally used to describe the weather in March, as it is typically cold at the beginning of the month and warmer by the end. This year, the saying also rings true as it relates to the stock market’s performance during Q2. The market pullback began in February with DeepSeek’s announcement of a lower-cost artificial intelligence (AI) model and continued into April as selling accelerated and broadened into cyclical sectors due to growing tariff uncertainty. At the lows, the S&P 500® traded down 19% from February highs as several strategists reduced their 2025 earnings estimates for the S&P 500® and many investors expected a tariff-driven recession. Market pessimism abounded with a sharp spike in volatility as measured by the CBOE Volatility Index or VIX, which jumped to over 50. The index is seen as a fear gauge as it measures expected market volatility over the next 30 days.
As is often the case after sizeable spikes in volatility, the market rallied sharply following the announcement of a 90-day tariff pause. By the end of the quarter, the market not only recovered from the sell-off but reached new highs with the S&P 500® up 10.9%. Three months ago, few foresaw a significant rebound. This begs the question: what changed? A big change was that tariffs were pushed out 90 days. This enabled countries to negotiate deals with several countries, either making deals or putting rough frameworks in place. The other major concern, that of slowing AI growth, has been largely debunked. Large technology companies, such as Meta and Amazon, have continued to increase data center investments subsequent to DeepSeek’s announcement. The bear case was that the AI spending had already peaked, and large capital investments were no longer required as more efficient models would require less hardware. In reality, we are in the midst of this era’s version of the space race: artificial intelligence. While software innovations will undoubtedly improve model efficiency, substantial computing power is needed to ensure that AI models and technology from American companies become the standard, much like during the Dot-com era. Additionally, the need for computing does not end with AI training. Each application that is developed will then run inference, which utilizes the trained model to draw conclusions from new data. These applications or agents will run indefinitely using live data until the training model is updated. This will enable the development and widescale deployment of new applications such as autonomous driving and robotics. AI will enable significant efficiencies as many tasks will be automated, increasing worker productivity.
The economy remained resilient, albeit with slower growth, despite tariff turmoil. While GDP decreased at 0.5% in Q1, growth is expected to resume in Q2 and remain positive for the balance of the year. Inflation remains subdued with the May CPI coming in at 2.4%. The tone from the Federal Reserve seems to be getting more dovish as inflation nears its 2% target, though they are being patient, waiting to see if there is potential tariff impact before reducing rates this Fall. The Fed is still expected to cut rates at least twice in 2025, with cuts coming as early as September. Employment is beginning to show signs of weakening, with an estimated 33,000 private sector jobs lost in June, though unemployment remains low at 4.1%. The Market rebound was led by growth-oriented sectors, including Technology (23.5%) and Communication Services (18.2%). Industrials (12.6%) and Consumer Discretionary (11.3%) also performed well as the market priced in the reduced likelihood of a tariff-driven recession and potential tailwinds from the reconciliation bill. The worst-performing sectors were Energy (-9.4%), Healthcare (-7.6%), and Real Estate (-1.0%). While tariff negotiations could cause a pullback near-term, the market could see further upside later this year as the administration begins to focus on pro-growth policies.
Portfolio Equity Positioning
During the 2nd quarter, we made several modest changes to the portfolio as news of tariff implementations and iterations came to light, as it was recognized that most sectors could be vulnerable, regardless of traditional safety haven status, and that each holding had to be scrutinized for elevated exposure to the new tariff realities and potential slower economic growth. Names that were identified as having elevated risk included Stanley Black & Decker (SWK), Disney (DIS), Target (TGT), Thermo Fischer (TMO) and American Express (AXP). The sale of Stanley was executed based on the company’s vulnerability with supply chain exposure, as greater than 60% (15%) of its product production is China-based. Disney was sold given its weakening theme park attendance and added risk of further consumer pullback given the greater probability of recession. Likewise, American Express was moved out of the portfolio as concerns around the consumer’s ability to maintain travel volumes and debt levels in a possible tariff-induced recessionary environment. Target was removed and replaced with Walmart, as it was believed that the retailers that would be rewarded would be those with the ability to push back on importers due to size and volume. Target was initially held with the belief that any modest improvement in growth of quarterly revenues and margins would entice an eventual rerating of its multiple, with patience being rewarded as it recovered from high-profile self-inflicted wounds. Finally, Thermo Fischer was sold as tariff pressures created an uncertain environment within the pharmaceutical and biotech space to move production back to US soil, raising projected costs and delaying or reducing research budgets for tools and equipment. Proceeds from the sales were used to purchase Walmart (WMT), Duke Energy (DUK), Charles Schwab (SCHW), and Tapestry (TPR). As mentioned above, Walmart’s size and scale can be effective in navigating tariff pressures and inventory challenges while proactively maintaining competitive advantages over smaller, more vulnerable retailers. Duke was purchased due to elevated structural demand for power across most sectors, but is currently driven by data center build-out. Duke is actively increasing its generation capacity through new projects and upgrades and recently received approval to extend the operating license for the Oconee nuclear station for an additional twenty years. They’ve also entered into a strategic partnership with GE Vernova for natural gas turbines. The company reaffirmed 2025 guidance with EPS growth rate of 5% to 7% through 2029, reflecting confidence in its operational execution. Charles Schwab was added due to significant asset growth and a 41% increase in earnings per share. The company is also seeing growth in wealth management and trading solutions. In the later part of the quarter, Tapestry was purchased, given the steady growth in market share in domestic and international markets, especially with younger shoppers. The company showed 27% growth in earnings per share and has little supply chain exposure to China as production is primarily sourced through Vietnam, Cambodia and the Philippines. The tariffs are manageable through the company’s ability to optimize its manufacturing footprint and shorter term, through inventory pull forward. In addition to new purchases, we took advantage of the early quarter pull back in our highest conviction names to add additional shares at reduced prices. Some of these included Eaton (ETN), Wells Fargo (WFC) and Meta (META).
Call Option Premium
Volatility, as measured by the VIX Index, spiked from the high teens to touch 60% as “Liberation Day” tariff announcements created considerable anxiety. When off-ramps emerged, investors caught their collective breath, allowing stocks to recover while market volatility hesitated, then fell persistently back to previous levels. Given the surge in volatility, opportunities to roll existing option positions were presented across most sectors as premiums on the existing positions collapsed with the down draft. Each call option position is evaluated as to its roll qualification based on our analysis of the underlying stock potential for positive price movement as well as option premium potential based on implied volatilities and delta. With that said, we stepped up roll activity to capture elevated premiums, resulting in solid income generation. Over time, the continuous addition of income dampens overall portfolio volatility and helps to generate solid returns for a reduced level of portfolio risk. Total income generation for the quarter was 3.8% annualized, while average days to maturity of the call options at initiation was 81 days, with 11.1% upside to the strike prices, while average portfolio percentage written was 55%.
Outlook
The market experienced a sharp rebound in Q2 despite tariffs and geopolitical concerns in the Middle East, with a number of the Magnificent 7 stocks leading the way. Following the rally, we could see greater near-term volatility as we reach the end of the 90-day tariff pause. That said, beyond potential tariff-related headwinds, there are multiple drivers for further market upside in the second half of the year, including trade agreements and Fed rate cuts. We continue to focus our efforts on maintaining a well-diversified portfolio with both secular growers and value stocks and look to add additional exposure to cyclical stocks that could benefit from pro-growth policies and Fed rate cuts. We believe that the market will broaden from here beyond the Magnificent 7 into cyclical sectors. We remain disciplined in our investing process and continue to look to take profits in holdings that become fully valued and add to positions of undervalued quality companies to enhance the risk/reward profile of the overall portfolio.
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