Market Commentary

Because It’s There

In 1923, when asked why he was attempting to reach the summit of Mount Everest, well-renowned mountain climber George Mallory replied, “Because It’s There.” This equally applies to the stock market, which continues to climb the proverbial wall of worry as the S&P 500 gained 7.8% in Q3. The market rally continued despite a myriad of worries, including ongoing tariff concerns, geopolitical turmoil in Europe and the Middle East, stubborn inflation, and a weakening labor market. On the trade front, while there were some trade deals, including the EU and Japan, which announced deals leading up to the July 9 expiration of the 90-day pause, other countries, such as India and Brazil, were hit with substantial tariffs. The pause on tariffs on China was extended an additional 90 days until November 10th. Inflation, meanwhile, remains elevated, though tariff impact has been lower than originally anticipated. The big driver in Q3 was the Fed’s shift towards a more dovish stance as the labor market continued to show signs of weakening. The market began to discount potential rate cuts leading up to the September Federal Reserve meeting, which led to outperformance from high beta and more speculative stocks. Small-cap stocks had a particularly strong quarter, up 12% for the quarter as measured by the Russell 2000® Index. Technology stocks, including the Magnificent 7 continued to outperform, though there was divergence between stocks as Tesla (+40%) and NVDA (+18%) had strong gains while META (-0.5%) and AMZN (0.1%) were laggards.

While Artificial Intelligence (AI) continues to drive the markets, the big news during the third quarter was the Fed’s pivot from a neutral to a more dovish stance with regard to its Fed funds rate. Lower rates, along with accelerated depreciation, should be tailwinds to not only datacenter spending but also spending for the associated infrastructure buildout, including electrical generation and transmission needed to power the data centers. The demand for associated industrial products is causing companies in the sector to expand production to better meet demand, as lead times for key equipment such as natural gas turbines have extended out to as much as 3-4 years. Given that power has become the limiting factor, data center providers have become creative in ensuring they will have the requisite power they need by building the data centers where electrical power can be added more quickly. Often, these locations are in the middle of the country rather than on the coasts where they were historically located. While there will undoubtedly be pullbacks in the stocks of AI-related companies leading the datacenter buildout, we believe that bottlenecks in areas such as power and healthy investor skepticism will enable the AI rollout to continue. That said, we recognize that monetization of AI is needed for further stock appreciation. We note that much of the spending up until now has been led by hyperscaler spending on the development and training of Large Language Models (LLMs). The next phase as recently discussed by OpenAI and Nvidia, will be led by inference, where companies in all industries leverage LLMs to drive incremental revenue growth, reduce costs, and increase worker productivity.

Following a 0.6% contraction in GDP in Q1, economic growth surprised to the upside in Q2 rebounding to 3.8%. Economic growth is expected to continue in Q3, with the Atlanta Fed’s GDPNow estimating 3.8% growth for the quarter. Despite strong economic growth, the employment market continued to show signs of weakening, with a lower than expected 22,000 jobs added in August, and for the first time in four years, there was a decline of 13,000 positions in June. The unemployment rate, while low on an absolute basis, increased to 4.3%. Inflation also ticked higher in August with the CPI increasing to 2.9%. Despite the pick-up in inflation, the Fed cut rates by 25 bp at its September meeting, given the weakening labor market, with an additional two cuts expected before year-end. In terms of sectors, the Market continues to be led by Technology (13%) and Communication Services (11.8%). Consumer Discretionary (9.4%) also performed well as the market began to price in rate cuts and consumer spending remains resilient, particularly at the high-end. The worst performing sectors were Consumer Staples (-2.9%), Real Estate (1.7%), and Materials (2.6%). While we could see a minor pullback following two strong quarters in a row, the market could see further upside before year-end if spending led by AI investments leads to market broadening into other sectors that are enabling the data center and power grid buildout.

Performance Attribution

Our top three contributors to performance for the quarter were as follows:

Alphabet Inc. (GOOGL) reported a strong quarter with significant growth driven by AI enhancements, leading to solid performance in Search, YouTube, and Cloud services. The Search service saw double-digit revenue growth, while YouTube and Cloud services continued to expand, with Cloud’s annual revenue run rate surpassing $50 billion. Google Cloud’s operating margin notably increased, and subscription revenues, particularly from YouTube, grew by 20%.

Tapestry (TPR) reported a record fiscal year with $7 billion in revenue and a 20% operating margin, driven by strong growth across its brands, particularly Coach, which saw its strongest fiscal year in history. Tapestry is taking action to mitigate much of the impact from tariffs, which will have some influence on profitability in the current year. Impacts will be limited through supply chain optimization and efficiency improvements in fiscal 2026. The company is expecting revenue of $7.2 billion with increasing operating margins as a buffer from declining gross margins due to tariffs, demonstrating financial agility and commitment to maintaining growth.

Oracle (ORCL) showed significant growth driven by its cloud services and AI workloads, with a 359% year-over-year increase in remaining performance obligations to $455 billion, indicating strong future revenue potential. Total cloud revenue grew by 27%, supported by a 500% increase in cloud RPO. Oracle also revised its cloud infrastructure growth forecast upwards, expecting it to grow 77% this fiscal year. Additionally, Oracle’s focus on AI and multi-cloud databases has resulted in significant revenue growth as well.

Holdings within the portfolio that were negative contributors to performance were as follows:

Salesforce (CRM) reported strong revenue growth of 10% year-over-year, driven by a 26% increase in net new bookings from deals over $1 million. The AI and Data Cloud product line saw a 120% year-over-year increase, with Data Cloud reaching $7 billion in revenues. The company also announced the rapid adoption of Agentforce, with 40% of new bookings this quarter coming from existing customers. However, the stock price performed poorly in the quarter due to concerns about the defensibility of SaaS against AI disruptions and the per-seat pricing model. Investor concerns center around the misalignment of cost structure vs revenue model, in which AI workloads have variable and sizable inference/compute costs that scale with usage, while charging a flat seat fee doesn’t capture that variability and can lead to margin pressure.  

Tyler Technologies (TYL) reported double-digit revenue growth, a surge in SaaS revenues by 21.5% accompanied by a significant increase in free cash flow. The company also highlighted its AI strategy with new AI features for multiple products expected by year-end.   The strong numbers and outlook were not enough to overcome investor concerns about the interplay between AI disruptions and SaaS offerings, very similar to investors’ concerns pertaining to Salesforce as explained above. However, the company reiterated that SaaS growth was firm with a positive outlook on customer retention and expansion efforts.    

Dover (DOV) reported a strong second quarter with a 16% increase in adjusted EPS and raised its full-year guidance, reflecting confidence in its second-half outlook supported by a solid backlog and positive order trends. Free cash flow also improved over the prior year. However, given the slow uptick in demand for short-cycle products such as refrigeration and vehicle services demand, it was felt that better opportunities were had with Caterpillar.

Activity During the Quarter

As discussed above, a pillar supporting the market and driving consistent returns is the AI capex spend. The tentacles of AI buildout reach across multiple sectors, but are specific within each. As such, we purchased Caterpillar (CAT) early in the quarter for its exposure to both the construction industry and power generation segment, which surged by 19%, primarily driven by demand for mini-turbines for data center applications. Several positions were also re-weighted in the case of called away positions and/or added to the weighting to increase exposure. These included Google (GOOGL), Apple (AAPL), Meta (META), Nvidia (NVDA), Duke (DUK), Broadcom (AVGO), Raytheon (RTX) and JP Morgan (JPM). Proceeds for the purchases were funded by sales in UnitedHealth (UNH), Dover (DOV), and NextEra (NEE). UNH was sold, given the revised 2025 outlook due to the company’s underestimation in Medicare Advantage medical cost trends. The other names were sold due to projected difficulties with sustaining margin levels while pushing out expected EPS acceleration.

Call Option Premium

Market volatility (VIX Index) remained remarkably subdued in the quarter as equities continued to recover from the tariff-tantrum sell-off in April. Volatility traded below 20 for the entirety of the quarter except for a brief spike related to the underwhelming Jobs Report released by the Bureau of Labor Statistics on August 1^st from which markets quickly recovered as the case for rate cuts became more prominent. In this environment, premium generation remained solid as individual equity implied volatilities remained consistently higher relative to volatility at the S&P500 Index level. Opportunities to roll in-the-money options were presented at various points in the quarter, from which strikes were moved out on the calendar and up in strike price. This process enables the portfolio to maintain original cost basis in the stock, thereby minimizing tax impact, while also allowing for upside participation in an upward-trending market. 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. Premium generation on a net basis (net of premium paid on the buy-back) was 1% simple and 3.9% annualized, while the average days-to-maturity of the call option at initiation was 90 days, with 10% upside to the strike prices. The portfolio was roughly 52% covered on average for the quarter.        

Outlook 

The market rally continued for a second consecutive strong quarter despite a litany of concerns, including tariffs, geopolitical concerns, stubborn inflation, and a weakening employment market as the AI buildout continues to drive economic growth with many of the associated benefits from higher productivity, lower costs, and incremental revenue still to come. While undoubtedly, we could experience a pullback after substantial gains off of April lows, there are multiple drivers for further market upside in the fourth quarter, including a potential broadening of the market from higher economic growth and Fed rate cuts. We continue to maintain a diversified portfolio with both growth and value stocks and look to add additional exposure to cyclical stocks that could benefit from pro-growth policies and Fed rate cuts. We remain disciplined and continue to use sharp spikes in stocks to take profits in holdings that appear extended in the near-term and add to positions of undervalued equities to enhance the risk/reward profile of the overall portfolio.

Important Disclosure Information

Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Connors Investor Services, Inc. “Connors”), or any non-investment related content made reference to directly or indirectly in this commentary will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this commentary serves as the receipt of, or as a substitute for, personalized investment advice from Connors. Please remember to contact Connors, in writing, if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services, or if you would like to impose, add, or to modify any reasonable restrictions to our investment advisory services.  Unless, and until, you notify us, in writing, to the contrary, we shall continue to provide services as we do currently. Connors is neither a law firm, nor a certified public accounting firm, and no portion of the commentary content should be construed as legal or accounting advice. A copy of the Connors’ current written disclosure Brochure discussing our advisory services and fees continues to remain available upon request. Historical performance results for investment indices, benchmarks, and/or categories have been provided for general informational/comparison purposes only, and generally do not reflect the deduction of transaction and/or custodial charges, the deduction of an investment management fee, nor the impact of taxes, the incurrence of which would have the effect of decreasing historical performance results.  It should not be assumed that your Connors account holdings correspond directly to any comparative indices or categories. Please Also Note: (1) performance results do not reflect the impact of taxes; (2) comparative benchmarks/indices may be more or less volatile than your Connors accounts; and, (3) a description of each comparative benchmark/index is available upon request.