Ray DiBernardo

Inflation, monetary policy, and changing sentiment around the potential of a Fed pivot were key contributors to the market’s choppiness over the last year. Find out what Covered Call and Equity Income Fund and Madison Covered Call ETF Portfolio Manager, Ray Di Bernardo, thinks markets will do in 2024, what the options market tells him about the stock market as a whole, and more.


Christopher Aleman

Hello, and welcome back to Madison’s video series of conversations with a PM. My name is Christopher Aleman, regional investment director for Madison investments, and I support advisors in the Northeast. This series is designed to bring our portfolio managers in to discuss relevant topics that you and your clients are seeing: recent headlines, stories that create uncertainty, opportunities that we are finding value in, and potential challenges to be on the lookout for. Today, I’m joined by Ray Di Bernardo, Portfolio Manager on the Madison Covered Call and Equity Income Mutual fund and active ETF strategies. Hi Ray, how’s it going today?

Ray Di Bernardo

Hey, Chris, good to be with you.

Christopher Aleman

Well, again, thank you for joining me. So I say let’s just dive right in. Despite the rally in November that we all saw the stock market has been in a kind of start stop cycle for most of the year. Is there merit to the rally? Or do you expect more choppiness, more of the same in 2024? And I guess to coincide with this, what macro factors are you looking at, as a covered call PM, that kind of support this?

Ray Di Bernardo

Yeah, well, it may be a little bit of a recap of the year because it has had some choppy periods. But generally, it’s been a pretty good year for the market, much, much better than we had anticipated coming into the year. We had some choppiness early in the year, and in February and March, when we had some concerns about the regional banking sector, we had a couple of closures there. But from early, mid-March through the end of July, the market rallied very, very strongly. And there were two real driving factors to that. The first one, you know, we had a rally in growth stocks, many of the names that had underperformed in 2022, rallied early in the year. And a lot of that was based on the issue of the Fed pivot. You know, the belief that the Federal Reserve was done raising rates, and may in fact, start cutting rates. So we had a little bit of a risk on rally that started in in March on that factor. But essentially, the Fed didn’t start cutting rates. And they actually raised rates in March, again in May, and again in late July. So that driver fizzled out. But the rally continued and was kind of driven later on in that period by the introduction of the concept of artificial intelligence, which really became a headline grabber. And it continued the rally in large cap or mega cap growth stocks right through the end of July. It became evident, though, that the Fed was not going to cut rates anytime soon. And then we were in a higher for longer type of interest rate environment. And that caused a bit of a rollover in the market. And we had a 10% or so correction from the end of July through the end of October, primarily based on concerns that the Fed was just going to keep rates high. November, as you noted, we’ve had a very, very strong rally, one of the best Novembers I think we’ve seen in the last 20 years. And inflation is coming down again, somewhat. There are there’s a view that the Fed may start dropping rates early in 2024. And we can have a proverbial Goldilocks scenario of a soft landing, no real recession, and we can have a continued bullish view in the market. So that’s really what’s been fueling the recent uptick in the market. How long that continues is anybody’s guess it’s a matter of who’s got the best crystal ball these days.

But, you know, the market or the expectations going forward have seemed to track two differentiated paths. The one is that continued bullish view of the market that I just kind of mentioned, that rates will start coming down because inflation is moderating, that the economy is still doing well enough to not go into recession. But it’s weakening enough for the Fed to start lowering rates, and that soft landing environment where corporate profits keep growing. I mean, right now expectations are for the S&P corporate profits to be up 10% next year. And the consumer, even though the jobs market is starting to show signs of weakness, the judge, the consumer is going to continue to be strong.

That’s the bullish case. The other path is more of a bearish case and one that we probably subscribe to more is that the lagged effect of this significant amount of fiscal tightening that started in 2022, early 2022, when the Fed started raising rates, is just now starting to have an impact on economic fundamentals. And that impact is going to grow significantly, as the months and quarters continue into 2024. So we believe that there’s a potential that we could have a recessionary environment next year and one that’s more severe than many are expecting. So there is a potential for the Fed to drop rates. But typically, the Fed drops rates in a recessionary environment only after the recession has hit. The Fed is typically reactive in these types of environments, and not proactive, so rates could come down. But before they come down, we could see some significant tariff variation and economic fundamentals. Typically, in that environment, corporate profits will be hit, the consumer will, which we believe is getting weaker, will continue to get even weaker, the jobs market, which is a lagging indicator, will weaken further. And we’re going to have tougher times ahead until we can finally move into the eventual other side of the cycle, which is a bull market starting at some point later on. But we think there’s more pain to be had before we get to that point. And, you know, that’s kind of our outlook, it’s a little bit more bearish than the other side. But, you know, we think that makes sense. That’s how we’re positioning our portfolio right now to invest in an environment that is going to be continually choppy for at least the first half of 2024.

Christopher Aleman

Let’s focus on that bearish case for a minute. In your last strategy letter to clients, you mentioned that there were headwinds facing the economy. I would like to touch on that a little bit more. But since we are present, you are positioned in the portfolio more defensive, I guess, what type of stocks are you looking for? Maybe touch on a name or two and the qualities that you identified that make it attractive for the strategy given the environment and the setting that you’ve just described.

Ray Di Bernardo

First of all, let me touch on some of those macro factors that those headwinds that you mentioned that we’re still concerned about. I mentioned the lag, there is a lag between when monetary tightening begins and when it has an effect on economic fundamentals. It changes cycle to cycle but you know, on average is somewhere around 18 months or so. So if you believe that tightening began in March of 2022, we’re actually beyond that point where, where the impact is starting to be felt, and we’re starting to see it in some of the economic numbers coming out on a month by month basis, we think those are going to continue to deteriorate, those economic fundamentals. So that lag is real. And even if the Fed were to start cutting rates today to protect the economy, the effect of today’s actions won’t be felt for 12, 18, 24 months into the future. So we still have to deal with the lagged effect of this very significant tightening cycle that was started back in 2022. The other factor that we’re really more concerned about is the consumer. I mean, the United States is driven, their GDP growth is driven by 70% or so by the consumer. The consumer has been very resilient of late. All of the money that was really injected into the financial system, post-COVID, has taken a long time to work through the system. And savings rates went up significantly, so consumers were not spending as much. Credit card balances were actually coming down fairly significantly, post-COVID. But now we’re in a position where much of that savings has been spent. The consumer has been strong, but they’ve been spending that pent up excess savings that they accumulated, and they’ve gone back to using credit again. So back in pre-COVID times at the end of 2019, for example, revolving credit or outstanding credit card balances in the United States was upwards of $925 billion. Post-COVID, when all of the money was put into the system, consumers paid off their debt, and that actually came down by about $150 billion, which is very good, balance sheets looked fantastic for consumers.

But today, not only have we eclipsed the previous highs and outstanding balances, but we’re now well over a trillion, almost at $1.1 trillion in outstanding balances, all at a time when the interest rate on those balances has gone from 15% at the end of 2019 to around 22% Today So the cost of having those bigger balances is taking away more and more disposable income from consumers. They’re still dealing with the impact of inflation. Even though inflation growth rates have come down, consumers don’t live on growth rates, consumers live on price levels. So we had an 8% or so increase in inflation and 2022. Even though that rate maybe three to 4% now, we’re still dealing with that 8% increase on top of another three to 4% increase this year. So unless disposable income keeps up with those, those increases, consumers just have less and less excess money to spend. And that’s what we’re really more fearful of is that the consumer is getting closer and closer to a point where they really have to retrench. And that’s going to really impede economic growth going forward.

So in that environment, you asked, what are we doing with the portfolio, we are clearly getting more defensive. Part of that defensiveness has been to move into sectors that have not performed as well this year that tend to be more defensive in nature. Utilities, for example, have been hit fairly hard this year. But that’s a sector that provides fairly consistent earnings and cash flow in many types of environments. So utilities, we’ve increased our weighting in. Consumer staples, again, typically a sector that does well in a, in a choppy environment. Those names have not done as well this year. Primarily because interest rates have gone up significantly, there’s competition against the higher dividend yields that consumer staples companies typically pay. And so there’s been some movement away from that sector. Some names in that sector, such as Pepsi, have been hurt by the recent craze of the GLP-1 diabetes drugs, which are now approved as weight loss drugs. So there’s a concern that there could be a massive shift in the way people shop and eat. We think that’s a little bit more broadly overdone. But Pepsi is a name that we’ve been adding to. We owned it in the past, it got really expensive, but over the last three or four months, it’s corrected by about 20% and valuations have come back down, and we think that’s a fundamentally strong company, one of the great consumer product branded companies in the world. And we’re happy to own it again at a cheaper valuation. So that’s an example of how we’re trying to get more defensive in our stock selection process, and in our sector allocation. We’ve also allowed many stocks in some of the higher flying areas such as technology and consumer discretionary, to get called away through option assignments. We believe they’re starting to get very expensive, we let the stocks get sold, and we reinvest that cash and much of that is going into some more defensive areas. But we’re not reinvesting all of that cash, we’re maintaining a healthy cash balance to take advantage of what we feel will be better buying opportunities as we get into 2024.

Christopher Aleman

Got it. Well, one of the things that you just mentioned, and I think it’s a key component of the strategy is going to be your active option writing. So because this is an active option writing, and we were just touching on letting some names you’d call the way, et cetera. Let’s talk about the options market a little bit. So first, when you are looking at the options market and the stock specifically, what exactly are you looking for, that makes it attractive to actually add to the portfolio? And then I guess, secondarily and I think more importantly, what is the options market telling you about the strength of the stock market? And what types of indicators are you focused on when you’re looking at it?

Ray Di Bernardo

First of all, when we’re looking at which options to participate in, it really for us comes down to our view of the underlying stock and the overall market to a certain degree as well. So if we believe there’s an upside to be had in the underlying holding, or the market in general, will tend to be a little bit more aggressive, and sell call options, maybe not fully cover a position with call options, maybe partially and or sell options that are further out of the money so that we can participate in more upside on the underlying stock. However, when we want to be more defensive, if certain companies are getting higher toward their valuation targets, we may sell options that are closer to the money so that we have a higher option premium, gives us more downside protection. And we’re getting closer to a point where we want to trim or sell the position anyway. So we really adapt the characteristic of the option that we utilize to our view of the underlying positions.

In terms of the overall options market and what it’s telling us, we get asked that question a lot. In reality, you know, a lot of the broad market indicators that come into the option side are, are somewhat less predictive than many might think. You know, they really are a measure of investor expectations. So, for example, volatility right now is very, very low in the short term, but if you look at the Futures Curve for the VIX index, for example, which measures short term volatility, short term or spot VIX levels right now are very, very low, primarily because the market has rallied so much. But there’s still an expectation that volatility over the next six to nine months will be significantly higher. In fact, the volatility curve, the Futures Curve looks very similar to what it did at the end of July, just before we had that correction. So there’s an expectation out there, that volatility will be higher as we get into 2024. If we look at something like the put-call ratio on the S&P 500, that can be an indicator of what expectations are and more recently, there have been a lot more call buying than put buying. So there’s much more of a bullish sentiment in the market. And the put call ratio is getting actually to fairly extreme levels, where you see extreme bullishness. Many, including us, use that more as a contrary indicator that when we get toward extreme levels on either the bullish or the bearish side, we typically want to start looking at the opposite view. So again, the put-call ratio is at similar levels to what we saw at the end of July. Excessive bullishness, we think that could be a measure that sentiment, if it’s going to change is unlikely to get more bullish is more likely to get less bullish and potentially at some point bearish. So that gives us some sort of indicator. So you know, we look at a lot of these indicators to give us kind of a sense of what expectations are. But many times, you know, these indicators aren’t as predictive as many would think, there’s really no silver bullet out there to help predict what exactly the market is going to going to do. It’s really based on expectations of what the broad crowd is looking for.

Christopher Aleman

Well, I think you’ve given us a sense of what you’re looking at the types of things you’re looking at. Let me finish this last point by saying, why and when would somebody be looking at a covered call strategy such as yours? What kind of markets risky, choppy, sideways, etc, are ideal for the strategy? And then I guess I’ll end with what should someone reasonably expect to see, you know, from a performance and income perspective, if we can just speak historically for now?

Ray Di Bernardo

A covered call strategy is a strategy in which an underlying asset whether it be an index or an individual equity is purchased. And a call option is written or sold against that specific asset. The call option could allow for some upside participation in the underlying security. But we collect a premium by selling that option which gives us downside protection. So the upside potential is limited by the strike price on the option and the downside protection is enhanced by the amount that we collect from a premium. So it’s a less volatile way of participating in at least a portion of the upside in an equity or an index.

I think covered call writing historically, has been geared around participating in the equity markets with the knowledge that, because you are giving away upside by selling call options, you won’t fully participate in bull markets. But the defensiveness of using the option strategy protects you in bear markets. So that’s really the concept behind covered writing is getting participation in the markets but getting that participation with less volatility expectations. You know, it’s been interesting because as interest rates were so low up until 2020, too many investors considered covered call strategies because they tend to turn off a lot of income, which, we do, and unless we’re buying the strategy for a hedge against market volatility, primarily because markets were going up most of the time. Since 2022, though more people are investing are interested in having a lower volatility hedging type strategy, and less so about the income because interest rates have gone up and there’s more of a competitive nature to 10-year Treasury in the 4% or 5% area than when it was in the 2% or lower area. Now, if we were to go to a recessionary environment, then, you know, we would expect markets to be very choppy, the strategy should do very well in a volatile environment, it has historically. And then as rates come down because the Fed will eventually drop rates, even when we start the next bull market, there will be a subset of investors that want to look at the strategy for income. So, it’s a strategy that works in very many different environments. Probably the worst environment for most is in a straight-up bull market where the strategy won’t keep up in a very strong bull market, but it will participate. And in any other kind of environment, we would expect reasonably good total returns from the strategy. From an income orientation perspective, there’s a certain cyclicality or counter cyclicality to the way we generate income, because we generate income not only from option premiums, or the collection of option premium, but from the realization of underlying capital gains from the stock holdings that we have. So in markets that are going up, we tend to realize more gains on the underlying positions, which is part of our distribution. And when markets are not going up, or going down, volatility is typically higher. So the income opportunity from the option side is greater and we collect more from option premiums. That historically has allowed us to have a fairly consistent flow of income in both choppy markets and bull markets. So our income expectations are fairly consistent year to year regardless of what is going on in the market.

Christopher Aleman

Well, that makes sense. And I think you’ve put a nice little bow on it in terms of what we’re actually looking for. So I think we’re going to wrap up there. So I want to say first, Ray, thank you for taking the time to speak with me today and give a little bit more insight into the options world and your strategy, specifically.

Ray Di Bernardo

My pleasure.

Christopher Aleman

So that was Ray Di Bernardo, Portfolio Manager on the covered call and equity income fund. To see more conversations with our PMs or to learn more about Madison’s suite of strategies, please visit Madisoninvestments.com or reach out to your regional director in your area. Thank you and take care.


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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.

The writer of a covered call option forgoes, during the option’s life, the opportunity to profit from increases in the market value of the security covering the call option above the sum of the premium and the strike price of the call, but has retained the risk of loss should the price of the underlying security decline.

An investment in the fund is subject to risk and there can be no assurance that the fund will achieve its investment objective. The risks associated with an investment in the fund can increase during times of significant market volatility. The principal risks of investing in the fund include: equity risk, mid-cap company risk, option risk, tax risk, concentration risk and foreign security and emerging market risk. More detailed information regarding these risks can be found in the fund’s prospectus.

An option’s strike price is the price at which the option holder has the right to purchase or sell the underlying security.   

An option is “at the money” when the current market value of the underlying security is the same as the exercise price of the option.

A call option is “in the money” when the current market value of the underlying security is above the exercise price of the option.

A call option is considered “out of the money” if its exercise (or strike) price is above the current market value of the underlying stock.

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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 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. An investment cannot be made directly into an index.

Chicago Board Options Exchange (CBOE) Volatility Index (VIX) measures market expectations of near-term volatility conveyed by S&P 500 stock index option prices.

For more information on options and related risks, contact your financial advisor and review the Options Clearing Corporation “Characteristics and Risks of Standardized Options” available at www.theocc.com.