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Portfolio Manager Commentary


Q3 2022 Covered Call Comments

by Robert Cagliola, CFA and Robert Hahn, CFA, on October 13, 2022

The third quarter is best summed up by the famous Dickens quote from A Tale of Two Cities: “It was the best of times. It was the worst of times.” The quarter began with the Market rebounding sharply off of June lows leading into the Fed speech at Jackson Hole in August. Following a weak Q2, the S&P 500 rebounded 18% off the lows to regain 4300. The Market rebound came to an abrupt halt following Fed Chairman Powell’s speech as the Fed reaffirmed an extremely hawkish view conveying, they will continue to aggressively raise rates until it becomes apparent that inflation is back under control even if Fed actions cause a recession. Prior to the speech, investors had expected that inflation would begin to subside after multiple rate hikes and quantitative tightening.

 The prevailing view was that much of the rate hikes were behind us after the September meeting and that inflation could be lowered without causing a recession. As a result of the Fed’s hawkishness, the market sold off significantly reaching new lows in September. As a result, the S&P 500® declined by 5.3% during the third quarter with the market erasing nearly two years of gains. Inflation as measured by the Consumer Price Index (CPI) rose 8.3% from August 2021 to August 2022, which was greater than expected driven by higher food and shelter prices. The Fed responded by increasing the Fed Funds rate by 0.75% to 3.00% -3.25%, the highest since 2008 and Powell’s commentary suggested that rate hikes will continue well above current levels. In addition, the Fed continued with quantitative tightening that began in June at $47.5B and accelerated to $90B by September. Investor concern that the Fed’s tightening and rate hikes could lead to a recession has increased following Jackson Hole as both stocks and bonds have declined for three consecutive quarters. That said, the Atlanta Fed’s GDPNow model predicts 2.3% GDP growth in Q3 following two consecutive quarters of negative GDP, which may give the Fed more leeway to continue aggressively fighting inflation. The S&P 500 (Energy) remains the only S&P sector in positive territory through the first three quarters. One point of optimism may be that the yield on 10-yr treasuries closed the quarter at 3.8% after nearly reaching 4.0% a few days earlier. Commodities also continue to decline from recent highs, with oil closing at $79.49 off its 2022 highs of $130.50. Stock performance in the fourth quarter will likely depend on a potential moderation in inflation and in the Fed’s pace of rate hikes and quantitative tightening with the upcoming earnings season likely to be cautionary in tone as rate hikes and quantitative tightening along with a strong dollar conjointly provide headwinds to economic growth.

Portfolio Equity Positioning:

Our positioning remained defensive as we maintained sector overweight exposures to Consumer Staples and Health Care, continuing to believe that markets would remain particularly volatile throughout the quarter and into year-end. In addition, we trimmed our sector overweight in Industrials to further reduce cyclical exposure while moving towards a more neutral stance. We continued to maintain an underweight in Technology and Consumer Discretionary sectors but may look to adjust this stance as opportunities arise.

Call Option Premium:

Market volatility, as measured by the VIX Index, moved steadily lower into mid-August as the market rallied on growing consensus views of a Fed pivot to a more benign tightening stance. However, as discussed above, this perspective quickly changed after Jerome Powell spoke at the Jackson Hole conference in late August, reiterating Fed determination to defeat inflation, economic pain notwithstanding. With that backdrop, premiums came in a bit early in the quarter but began to elevate into September. Average premium generated on call option sales was roughly 1.7% on fully written positions. The average participation to upside strike price and tenor was roughly 10% and 78 days, respectively. With September’s pullback, much of the premium capture has been realized with existing overwrites, and therefore, each position is reassessed as to its recovery potential versus premium tradeoff on roll forwards. For example, several names within our healthcare sector will be written at strike prices within 10% of current prices as these names have held up well and continue to experience less volatility than the market in general. On any market recovery, these equities will most likely participate in an upside rally but not necessarily lead with the voracity of cyclical stocks within the Technology, Consumer Discretion or Industrial sectors. With market volatility exceeding 30 as measured by the VIX Index, significant premiums can be obtained with much wider bands of upside participation for these economically sensitive sectors. Thus, option positioning within these cyclicals will of course depend on our view of when such a recovery is possible.


The market direction going forward is very dependent on the Federal Reserve’s view of inflation and the degree of rate increases along with quantitative tightening. Simply put, when inflation data declines, the market will bottom. We are currently seeing numerous commodity and goods inflation indicators roll over as demand and supply have caught up to each other over the past few weeks. Nevertheless, pressure on earnings are substantial as sticky wage costs will continue to rise and eventually level off at a higher sustained plateau. If consensus earnings on the S&P 500 Index falls by 10% from its current estimated level of $240, an earnings number that very few investors believe to be real at this point, then the current multiple of 15x suggests 3200-3300 level on the index in the near term, or 8% to 10% lower from its quarter end finish. With that said, markets adjust quickly to perceived changes in tone or actions of the Fed and economic realities. The impact of rate increases will lead to quicker deceleration of inflation and economic growth, leaving the question as to when the Fed will begin discussing slowing restrictive policies and ultimately cutting rates. Investors currently feel that any timeline for this will be the 2nd half of 2023 at the earliest. Markets will begin discounting this scenario 6 to 9 months ahead of time, possibly in the next few months. Therefore, going into year end, the possibility of a market rally is growing more likely but this begs the question from what level. Corporate earnings announcements are coming over the next few weeks and will most likely lead to more volatility in the short term before the assessment is priced in on any possible Fed pivot. With all that said, even though markets are at elevated risks in the short term with earnings announcements coming soon, we will maintain our defensive positioning but look for opportunities to upgrade the portfolio to participate in upside moves, should they happen, that will come fast and furious on any positive surprises. These are impossible to time accurately. Many studies have shown that missing the top-performing days of any recovery greatly reduces overall long-term performance for investors. Though markets are likely to continue to be challenging for the foreseeable future, it is exactly the type of environment which provides the base from which future returns may be realized.


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Topics:Covered Call Comments

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