atiatiati
Covered Call strategies, by their nature, are defensive. They are structured to knowingly sacrifice a portion of upside growth potential in order to provide additional downside protection. The Madison Covered Call & Equity Income Fund does exactly that by owning a very high quality portfolio of individual equities and selling equity call options on the portfolio holdings. The Fund offers a solid total return platform which includes capital appreciation and a high distribution rate which is primarily sourced from call option premiums and realized capital gains on the underlying portfolio. It is a relatively concentrated, actively managed portfolio, providing a risk-reduced way to participate in US equity markets.
Prepper’s Dilemma
Whether preparing for a bad storm, the devolution of social order, or a run-of-the-mill zombie attack, there is always a chance that nothing happens and the world continues on its current path. The prepper’s dilemma stems from questioning whether prepping was ever worth the effort. There is clearly a benefit from riding the status quo without worrying about any potential pitfalls. It’s fun while it lasts.
However, when something inevitably goes awry, most people try to prep after the fact. Bottled water or toilet paper become scarce commodities or evacuation routes become parking lots because everyone waited until the last minute to escape an oncoming storm. We see this type of activity in the investment world as well. Buying begets more buying even when fundamentals appear to be weakening and valuations are unreasonably high. This is referred to as FOMO, or the fear of missing out. When markets collapse, investors tend to sell into weakness, exacerbating the downward trend. Protective investment strategies become very popular only after they are most needed. None of this is ideal but it is human nature.
It’s important to realize that prepping provides a level of risk management or insurance against unfavorable events. That is sensible even in periods where unfavorable events are few and far between. Since November of last year, the status quo for the S&P 500 has been to grind higher even in the face of weakening economic data, high valuations, domestic political uncertainty and rising global risk factors. Other than a wobble in early August on Yen carry trade concerns, the equity market has largely ignored the growing risk factors. Much of the market’s resilience has been related to the “AI” trade which elevated many large cap growth companies to superstar status. Interestingly, this trend seems to have run its course, at least for now, as large cap growth stocks lagged their large cap value cousins during the third quarter.
The other driving factor for the market has been the long-expected Fed rate cut that finally occurred in September, with the Fed cutting by 50 basis points. It should be noted that when the market rally began last November, rate cuts were expected to begin in March 2024… better late than never, apparently. Although inflation growth has receded from extremely high levels, prices are still rising, and consumers are increasingly challenged. We continue to hear that the economy is in good shape or, at worst, about to land softly. We are not so sure about that. The impact of interest rate changes has a lagged effect on economic activity. The weakness that we are beginning to witness is due to the tightening of rates that began in 2022. The September Fed cut and any further cuts will not have their effects felt for many quarters into the future.
The recent resilience of the equity market is surely to be tested given the numerous crosscurrents facing the economy at present. We are not suggesting that you build an underground bunker in the Northwoods of Wisconsin, but only that you maintain a reasonable risk management posture. However, if zombies do attack then all bets are off.
Q3 2024 Performance Review
The third quarter was not an uneventful period. The Yen carry trade caused a short-term decline in U.S. markets. Chinese equities collapsed on economic growth fears and then rebounded as the government announced massive stimulus plans. On the domestic political front, the incumbent President dropped out of the election while the previous incumbent was the target of two assassination attempts. Global oil prices declined sharply, firstly on concerns of slowing demand from a slowing global economy and then from supply concerns on rumors that OPEC would flood the market. Citing declining inflation and a steady job market, the Federal Reserve instituted a long-awaited rate cut but decided on a larger 50 basis point cut rather than an expected 25 basis points. Economic data continues to trend toward a declining economic environment but still good enough to not instill much fear. In all, equity markets leaned toward maintaining the bull market trend, with the S&P 500 gaining 5.9%. The CBOE S&P 500 Buy-Write Index (BXM) closely tracked the S&P 500, rising 5.5%. The Fund lagged given its very defensive posture but participated reasonably well, gaining 4.7% (Class Y).
From a style and sector perspective, the S&P 500 diverged from being led by a small group of mega-cap growth stocks toward broader value-oriented leadership, which included Utilities, Industrials, Financials and Material sectors. Previous leading sectors such as Technology, Communication Services, and Consumer Discretionary all were among the bottom half of sector performers. The Energy sector ended in negative territory as the price of crude oil (West Texas Intermediate) declined almost 14% during the quarter. The price of Gold rose 13% during the quarter and is almost 28% higher on a year-to-date basis.
The Fund’s sector allocation relative to the S&P 500 resulted in additive performance. As the Fund has been positioned in a defensive posture, it benefited from an overweighting in the Utilities and Consumer Staples sectors while being significantly under-represented in the Technology sector. The Fund was also helped by an above-average exposure to gold related companies. An over-weighting in the lagging Energy sector slightly offset the gains in the other sectors mentioned above.
Performance of the Fund’s individual equity positions also added relative value as compared to the overall index. Just as in previous quarters in which the Fund did not participate in the flight to mega-cap growth companies, it did not suffer in the current quarter as most of those names lagged. Performance leadership came from Newmont Corp. (NEM) (higher gold price), Ciena (CIEN) (strong earnings and optical equipment backlog), PayPal (PYPL)(resurging competitive strength in payments), T-Mobile (TMUS) (consistent free cash-flow generation and Sprint merger-related efficiencies), and Starbucks (SBUX) (new CEO).
Most of the underperformers were in the Energy sector and suffered from the short-term negative volatility in crude oil prices. The main laggards were Transocean (RIG), Matador Resources (MTDR), and Apache. Dollar Tree (DLTR) was a recent purchase on weakness following a poor earnings report and the stock continued to drift lower. We view this as an opportunity within a retail sub-sector, which is typically resilient during recessions. Constellation Brands also lagged early in the quarter on concerns around their wine/liquor business, however, the stock rebounded nicely in September with beer trends continuing to be strong.
With stock selection and sector allocation being additive to relative performance, the Fund’s overall underperformance against the S&P 500 was due to the call option overlay and relatively high cash positioning. The Fund remained very defensively postured with call option coverage in the mid-80% area as it has been for most of the year. Cash levels rose slightly during the quarter as the steady market rise led to numerous option assignments and the need to reinvest the subsequent cash. As the market is expensive, in our view, it has been challenging to reinvest in attractively valued, high quality companies. We prefer to maintain a higher cash holding until more attractive opportunities present themselves.
The Fund’s income generation capabilities remain strong, and its defensive characteristics are well positioned to provide a measure of protection against any future market dislocation.
Outlook
Typically, outlook sections only look forward, but given the unusual fiscal and monetary circumstances of the last few years, crystal ball gazing has become much more challenging. So, here’s a quick look backwards. In response to Covid, the money supply skyrocketed by 20%/year for 2 years as the Federal Reserve kept the Fed Funds rate near zero and over-the-top fiscal stimulus programs were enacted. Post-lockdowns, the economy recovered quickly given the sugar high of excessive money supply and unsurprisingly, inflation soared. It took over a year for the Fed to determine that inflation was not transitory and that a significant monetary tightening cycle would be required. Given the sheer size of the monetary and fiscal stimuli, it has been challenging to project when the positive effect of the mountain of money would dissipate. These effects have arguably lasted longer than we anticipated. We believe that the positive effects are beginning to wane and the negative effects of the subsequent monetary tightening will take hold moving forward despite the Fed’s recent actions.
With the consumer tapped out and corporate America re-adjusting to normalized inflation (ie less inflated revenue but sticky inflated expenses), we expect economic fundamentals to weaken. Although consensus earning growth for the S&P 500 has flattened recently, it is still projecting 14% growth this year to next. The market is trading at almost 21x that projected earnings growth level, very close to levels last seen in late 2021 just prior to the last bear market. We foresee the earnings growth rate to have more downside risk than upside potential and with valuations relatively high, any meaningful reduction in earnings growth may also induce multiple compression. At best, this would lead to higher volatility in equity markets and a reassessment of market expectations.
There is an expectation that covered call strategies are defensive in nature. We strongly adhere to this belief and will typically err toward being too defensive rather than too aggressive. Protecting against downside risk is what preppers should do and, as such, we remain defensively postured.
Sincerely,
Ray Di Bernardo & Drew Justman
Disclosures
Indices are unmanaged. An investor cannot invest directly in an index. They are shown for illustrative purposes only, and do not represent the performance of any specific investment. Index returns do not include any expenses, fees or sales charges, which would lower performance.
The CBOE S&P 500 BuyWrite Index (BXM) is a benchmark designed to track the performance of a hypothetical buy-write strategy (i.e., holding a long position in and selling covered call options on that position) on the S&P 500 Index.
The S&P 500® is an unmanaged index of large companies, and is widely regarded as a standard for measuring large-cap and mid-cap U.S. stock-market performance. Results assume the reinvestment of all capital gain and dividend distributions.
A basis point is one hundredth of a percent.
“Madison” and/or “Madison Investments” is the unifying tradename of Madison Investment Holdings, Inc., Madison Asset Management, LLC (“MAM”), and Madison Investment Advisors, LLC (“MIA”). MAM and MIA are registered as investment advisers with the U.S. Securities and Exchange Commission. Madison Funds are distributed by MFD Distributor, LLC. MFD Distributor, LLC is registered with the U.S. Securities and Exchange Commission as a broker-dealer and is a member firm of the Financial Industry Regulatory Authority. The home office for each firm listed above is 550 Science Drive, Madison, WI 53711. Madison’s toll-free number is 800-767-0300.
Any performance data shown represents past performance. Past performance is no guarantee of future results.
Non-deposit investment products are not federally insured, involve investment risk, may lose value and are not obligations of, or guaranteed by, any financial institution. Investment returns and principal value will fluctuate.
This report is for informational purposes only and is not intended as an offer or solicitation with respect to the purchase or sale of any security.
Consider the investment objectives, risks, and charges and expenses of Madison Funds carefully before investing. Each fund’s prospectus contains this and other information about the fund. Call 800.877.6089 or visit Madison Funds to obtain a prospectus and read it carefully before investing.
Although the information in this report has been obtained from sources that the firm believes to be reliable, we do not guarantee its accuracy, and any such information may be incomplete or condensed. All opinions included in the report constitute the authors’ judgment as of the date of this report and are subject to change without notice. This report is for informational purposes only and is not intended as an offer or solicitation with respect to the purchase or sale of any security.
Madison Asset Management, LLC does not provide investment advice directly to shareholders of the Madison Funds. Opinions stated are informational only and should not be taken as investment recommendation or advice of any kind whatsoever (whether impartial or otherwise).
Madison Funds are distributed by MFD Distributor, LLC, member FINRA.
Madison-618965-2024-10-09
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