Market Commentary

“The reports of my death are greatly exaggerated” is a famous quote attributed to Mark Twain following inaccurate rumors of his death. After a 7.5% bounce in Q1, many investors expected the death of the market rally or a market pullback at a minimum, given numerous headwinds, including the debt ceiling, the collapse of Silicon Valley Bank, and concerns of a recession in the second half of the year. Instead of declining, the S&P 500® Index rose 8.3% in Q2 as the market climbed the proverbial wall of worry. The debt ceiling crisis was avoided following an agreement in Washington, D.C. and positive results from the Federal Reserve’s (“Fed’s”) stress tests helped restore confidence in our financial system and enabled banks to increase dividends and stock buybacks. Most importantly, the inflation rate continues to decline, coming in at 4% year-over-year in May as measured by the Consumer Price Index (CPI). This compared to 4.9% in April and allowed the long-awaited pause in the Fed’s interest rate hike program. The economy has remained resilient despite a 500 basis point (5%) hike in rates over the past year. The labor market remains strong, with non-farm payrolls beating expectations for 15 consecutive months. During the second quarter, Technology extended its outperformance for the year, with the sector up 16.9%. Consumer Discretionary and Communication Services were the next strongest performing sectors, up 14.3% and 12.8%, respectively with much of the gains driven by mega-cap names such as META +35%, AAPL +17.6, AMZN +26.1% and MSFT +18.1%. Underperforming sectors included Utilities -3.3%,and Energy-1.8%. We point out that there was some broadening of the market rally later in the quarter, with Industrials and Materials up 11.2% and 10.8% in June, respectively. Despite the positive economic data points, inflation remains well above the Federal Reserve’s 2% target rate. Commentary from the Federal Reserve suggests up to two additional 25 basis point (0.25%) interest rate hikes before year-end, creating the potential for some near-term retracement. Stock performance in the third quarter will likely depend on upcoming CPI numbers showing a further moderation in inflation.   While markets could see a near-term pullback, we expect further (market) upside if/when the Fed completes its rate hiking cycle.

Portfolio Equity Positioning

Like last quarter, we continued moving the portfolio from a defensive posture to a more neutral sector exposure versus the S&P 500®. Staying true to our discipline, we sought quality companies with solid cashflows, low debt, and consistent and growing earnings. As such, several names were added to the portfolio, including Zoetis, Morgan Stanley, JP Morgan, Lowes, and Stanley Black & Decker. The latter two are well positioned to benefit from strength in new home demand and a strong consumer. Positions sold included Devon Energy—weak oil demand and slower China recovery, Target—inventory concerns and negative mix shift, Goldman Sachs—swapped for JP Morgan who has more consistent and diversified earnings stream, Nike—inventory concerns and decelerating direct to consumer sales, and Disney—lack of profitability in streaming and disappointing movie studio box office numbers.   In addition, several names were called away early in the quarter and repurchased, included Linde of total portfolio value), McDonalds, and Advanced Micro Devices Inc. At quarter end, the portfolio maintained the largest relative sector overweight exposures in Health Care (16.8% of portfolio value), Industrials (12.3%), and Consumer Staples (8.7%), while Technology (23%), Consumer Discretion (9.1%) and Communication Services (7.5%) have the largest underweights.

Call Option Premium

The VIX Index declined by 27% to 13.25 in a steady retracement throughout the quarter, with brief spikes in May related to Fed Chairman Powell’s “higher for longer” hawkish rhetoric in the post-Fed meeting testimony and again as the debt ceiling negotiations took center stage. In the end, investors looked past these distractions toward falling inflation expectations and an end to interest rate hikes. Given the lower volatility and desire to generate meaningful income, implementation of call writing on equity positions was generally executed in the 30-delta range (a higher delta translates into more premium income but generally less upside and/or longer option duration.) The generated premium was roughly 1.02% for the quarter (4.2% annualized) on a gross basis, netting to 0.7% for the quarter (2.8% annualized) after considering capital used to roll existing positions out on the calendar and up to higher strike prices. Often the decision is made to keep the existing shares intact by rolling call options to participate in additional upside for the underlying equity position. The average position was written with 8% upside potential and 96 days to maturity. The portfolio was roughly 52% covered with written call options at the end of the quarter.

Outlook

We believe that the market in the near-term seems ripe for some retracement given the stock market’s significant appreciation in the first half and the potential for two additional interest rate hikes in upcoming Federal Reserve meetings. The direction from here is predicated on a further decline in inflation and more dovish monetary policies. That said, the economy is growing better than expected, with 2% GDP growth in Q1 and continuing strength in the labor market. Despite tighter lending standards and higher interest rates, the economy has chugged along in part due to infrastructure spending both by the government as well as reshoring which requires manufacturing and supply chain facilities and warehouses. Housing has also been another area of strength despite higher mortgage rates due to demographics and a lack of supply of starter homes as Millennials form new households. While we cannot predict near-term market movements, we maintain a balance of both secular growth and value exposure and look to add to positions on any pullbacks. Looking forward, there is potential for higher volatility following the extended market advance. We think any increase in volatility would benefit covered call strategies. 

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