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 (-9.0%), Microsoft (-3.8%), Amazon (-3.6%) and Nvidia (-1.7%). 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) 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 still challenging macro housing environment. Dover Corp (DOV), a provider of engineered products and clean energy solutions, was purchased after showing strong improvement in organic growth of 5% and bookings up 16% in year-over-year comparisons. The company also raised earnings guidance for the full year and continues to move its portfolio towards higher growth and margin opportunities. Broadcom (AVGO) 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) 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), Meta (META), and Tyler (TYL). 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) 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), Honeywell (HON), and Emerson (EMR). 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.

Other funding sources for purchases were realized from partially called-away positions, including Eli Lilly (LLY), Coca-Cola (KO), Oracle (ORCL), RTX (RTX), and Welltower (WELL). 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% (4.9% 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% (4.5% annualized), while the average days to maturity of the call options at initiation was 99 days, with 10.5% upside to strike prices, and the portfolio average percentage written was 60%.

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 sectors 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 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.