Cboe Global Markets

Inside Volatility Trading: Mercury and Market Retrograde

Kevin Davitt
▬
February 15, 2022

The moments are mine, if I can just seize the day

But then I forget what it is that I meant to say

I try to hold on, but never too tight

The hours go by until Mercury comes out at night

-Anastasio/Marshall

Celestial Connections

Astrology tries to glean useful information by studying celestial objects. While I do not put much stock in the pseudoscience, according to astrology, there are three or four periods during a calendar year when Mercury is in retrograde. During “retrograde” periods, the planet Mercury appears to move backwards. Astrological subscribers believe that communication and technology can be impaired when Mercury is in retrograde.

This isn’t an attempt to dismiss the study of objects in the sky. In many ways, market participants behave similarly and attempt to discern trends and identify opportunity based on specific relationships. For example, using price-to-earnings ratios, analyzing the impact of interest rates on U.S. equities, or examining the relative performance of growth and value stocks.

Participants continuously compare one variable relative to another. 

Some unusual things have occurred in capital markets lately. What are the shifting relationships potentially saying about the future?

Technology (Impaired)

Perhaps it was in the stars, but the technology sector has been particularly distressed of late. The chart below plots the performance of the Cboe Select Sector Technology Index over the past six months. From late December to late January, this technology barometer declined by more than 14%. By comparison, the S&P 500 Index fell by 9.8% over a very similar time frame. 

Every constituent stock in the S&P 500 Index can be broken down into one of eleven sector categories. Each sector has its own weight within the index. The Technology sector is by far the largest. Below is a breakdown of sector weights as of the end of 2021:

Cboe Technology Select Sector Performance Over 6 Months

Source: Cboe Global Markets

Every constituent stock in the S&P 500 Index can be broken down into one of eleven sector categories. Each sector has its own weight within the index. The Technology sector is by far the largest. Below is a breakdown of sector weights as of the end of 2021:

S&P 500 Index Sector Weights

Source: S&P Dow Jones Indices and Cboe Global Markets

The weightings change over time and the influence of technology has steadily increased. For example, at the end of 2018, technology accounted for 20.12% of the S&P 500 Index. Now, tech makes up 29.17% of the index.

In 2022, the second most influential group is health care at 13.29%. Based on current weights, technology stocks have more than double the impact of health care names in the S&P 500 Index. Naturally, the relationship between technology stocks and the S&P 500 Index is highly correlated.

As goes General Motors, so goes America… has evolved into: As goes Apple, Microsoft, Amazon, and Alphabet, so goes the U.S. economy. The current version of this saying is a generalization but is reflective of the weightings of technology stocks within the S&P 500 Index.

Interest Rates

The price of government bonds, particularly those with shorter maturities have declined considerably over the past seven months. The price and yield for a bond move in opposite directions; when bond prices fall, yields are increasing. There’s been a significant move in bond prices and respective yields.

For example, in mid-June 2020, the yield on the U.S. 2-year treasury was 0.17%. As of February 11, the U.S. 2-year yield was 1.60%. Longer-dated bond (10Y, 20Y, 30Y maturities) yields have also increased, but not with the same velocity as the short end of the yield curve.

The relationship between U.S. Treasury (UST) yields with different maturities is a scrutinized data point. Individuals and institutions often choose to borrow money (use credit) to finance their lifestyle or grow business. Many interest rates from mortgage and credit card rates to overnight lending rates between banks are sensitive to the U.S. yield curve. The UST term structure has been flattening since mid-2021. Many argue that it’s only a matter of time before the yield curve inverts. Historically, there have been recessions which have occurred when there have been yield curve inversions.

10 Year Treasury Constant Maturity Minus 2-Year Treasury Constant Maturity

Source: St. Louis Fed

In fact, a dynamic where short-dated bond yields are higher than longer-dated bonds can reinforce an economic slowdown. The cost of capital is perhaps the most important component for evaluating so many other market relationships. Any investment that involves borrowed money becomes more expensive when the cost of capital increases. More is spent on interest payments. Higher rates incentivize saving (as opposed to consumption) which impacts businesses and the economy as a whole.

Rates & Earnings, An Example

Interest rates have a meaningful impact on the value of future earnings for individual equities. Let’s explore this relationship.

The return from an equity could arguably be broken down into a few components. They include:

  • Yield
  • Growth
  • Changes in valuation

Ultimately a company’s stock price and valuation may be reflective of its future cash flows discounted by some interest rate. That gives you a net-present value of future earnings. From that you can extrapolate a valuation.

A basic discounted cash flow model is below:

Cash Flow Model 

Let’s assume that Company A expects to receive a single cash flow of $1000 ten years from now. That’s our numerator. The interest rate is our denominator, and we use two values to compare. In one example we’ll assume interest rates at 0.50%. In the second situation, we’ll assume 5.0% interest rates. The output is the net-present value of that future cash flow.

  • Present value of $1000 assuming 0.50% = $951.35
  • Present value of $1000 assuming 5.0% = $613.90

The difference of $337.45 for the net present value (NPV) of $1000 in the future is entirely a function of higher interest rates. In other words, the NPV of future revenue is 35% lower because of the higher discount rate. The relationship between the cost of capital and future earnings can be significant!

Now, how does this relate to share price and valuation?

Valuation, An Example

We’re going to build on our above example and introduce a couple of assumptions. The goal is to arrive at a hypothetical share price/valuation for Company A.

Valuation is straight forward when you know stock price and shares outstanding.

For our example, we’ll solve for earnings and then apply a typical P/E ratio for a technology company to give us a share price. The P/E ratio for many IT stocks is ~30. In other words, their share price is typically about 30 times annual earnings.

We showed that the value of future revenue (cash flows) is reduced when interest rate assumptions increase. To arrive at a hypothetical earnings number, we must make an assumption about the cost of goods sold (COGS). The COGS is the sum of what it costs Company A to make and deliver their product.

We’ll keep the COGS figure constant across examples but note that the COGS would likely be higher in a higher interest rate environment.

Let’s say that the COGS works out to $400 no matter the interest rate environment. We subtract this amount from the NVP of Income to find our earnings value.

Calling attention to the right side of the table above, you’ll notice that earnings are significantly lower when rates are higher because our discounted revenue value is lower.

Our example is simplified, but this dynamic has likely played out across U.S. equity markets for months. Higher rates have likely put downward pressure on the value of future earnings and valuations, most notably in the growth focused tech sector.

Let’s tie this all together with a hypothetical share price. In this next table, we use the earnings from the first visual and assume Company A only has 100 shares of outstanding stock. That makes calculating our earnings per share very easy. We take the (total) earnings number from above and divide by shares outstanding (100). Finally, we apply the “average” P/E multiple for tech companies – 30 -- to arrive at a hypothetical share price. Notice the impact of rates on share price.

The relationship between interest rates, earnings, and potential valuation/share prices is becoming clearer. Higher rates reduced the value of future earnings, and our stock price is 60% lower as a result. Portfolios with significant exposure to growth companies have been in retrograde.

Growth

Growth rates and future earnings are inextricably connected. In general, technology companies are focused on scale. The pursuit of scale tends to be internal as well as external. Tech companies often need to increase their user base to generate higher incremental revenue (internal). Their products often allow end users to do more with less (external).

Examples:

  • ETSY allows crafters to reach a much broader market of potential buyers than someone dependent on a brick-and-mortar store in one physical market.
  • TWTR allows Elon Musk to “communicate” with his 73 million followers with little friction.

Companies like ETSY and Twitter can be dependent on user base growth for future earnings.

ETSY Year-Over-Year (YoY) Growth By Quarter 2015 - 2021

Source: MacroTrends

ETSY is an example of a company that benefitted from the pandemic. You can see the huge revenue growth for the firm in 2020. The growth narrative boosted share price, but ultimately that growth wasn’t sustainable.

Low interest rates allowed growth companies to pursue “scale” with cheap dollars. The interest rate backdrop is changing, and growth stock prices have likely reflected the shifting relationship.

There are a wide variety of tech/growth stock charts that look nearly identical to ETSY’s; the given growth company’s stock moves higher between April 2020 and late 2021 followed by a 50-60% since early November.

ETSY Performance MID-2019-Present

Source: Cboe LiveVol Pro

Cathy Wood’s ARKK ETF, which primarily invests in technology companies, is a broader example. The fund is down 24% YTD (reference $71.50) and the average ARKK component has lost 63% of its value from 2021 highs.

Value

Value companies often command much lower price to earnings ratios. Investors aren’t normally willing to pay the same multiple for future earnings in companies that aren’t expected to grow rapidly. Value companies often pay out a dividend stream which makes them more attractive during “risk off” or low growth periods.

Over the past two months, there’s been a noticeable outperformance on the part of value stocks relative to growth. The story over the past decade, however, is quite the opposite. Growth companies have dominated during a decade with historically low rates. Furthermore, the pandemic drove demand for IT products that facilitated the “new normal” work environment.

It remains to be seen whether we’re experiencing a “sea change” where value stocks lead for years or not. The last period of significant outperformance on the part of value took place between mid-2003 and late 2007.

Below is a chart that tracks the Fed Funds rate between 2003 and 2010. Value stocks started to outperform when the Federal Reserve (under Greenspan) communicated their intent to tighten policy. Value fell out of favor in the middle of 2007 following a UST yield curve inversion and looser monetary policy (under Bernanke).

Fed Funds Growth Rate 2003-2010

Source: MacroTrends & Cboe Options Institute

So, there’s been a historical relationship between interest rates and the relative appeal of growth or value stocks. In general, growth stocks are more attractive in a declining interest rate environment. Value stocks have a history in which they often outperform during rate hike cycles. Interest rates are like the sun- at the center of this investment universe.

Here & Now

So far, 2022 has looked quite different when compared to last year. The S&P 500 Index fell nearly 10% from highs. Compare that to last year when the largest peak to trough drawdown for the S&P 500 Index was 5.2%. The pullback in the Nasdaq 100 Index was even more pronounced at 15.5%. The Nasdaq 100 is technology (growth) focused and the marketplace has been repricing the risk of rising rates. Tech stocks have been more sensitive, which is similar to the dynamic observed between 2003 and late 2007.

The S&P 500 Index has experienced meaningful dispersion with respect to sector performance. In January, energy advanced by 18.8% whereas consumer discretionary fell by 9.5%. Historically performance spreads of that magnitude have only been observed in “high vol” markets. 

S&P 500 Index Sector Spread

Source: S&P Dow Jones Research

Finally, in late January/early February of last year, market participants drove the Cboe Total Put/Call ratio to record lows. Calls, particularly well out-of-the-money calls were in huge demand. In early February of this year the total put volume relative to calls is at the highest levels since April of 2020. Put options appear to be back in vogue. Market participants seem more interested in downside protection than upside exposure.

Still new to the options market or simply interested in smaller exposure? Cboe is excited to introduce Nanos. These first-of-their-kind options have a one-multiplier, are cash-settled, and are available for trading on the S&P 500 Index in March 2022.

Big picture, the relationships between distinct data points can be informative. I didn’t notice any unusual communication or technological issues when Mercury was in retrograde. We have, however, explored the evolving relationship between the S&P 500 Index, the component sectors, and the impact of interest rates on futures earnings and market rotations.

We’ll see what’s in store for the Fed Funds rate on March 16.

As for the next time when Mercury is in retrograde, you’ll have to wait until May 10. 

Industry News

Events

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