Apple IncLong
Harvesting Alpha with Beta Hedging
Imagine this. Dark skies, earth tremors and thunder roars. Shelter is top priority. Size matters in a crisis. When the tsunami strikes and lightning splits the sky, investors shudder in fear; But the super seven stand tall, shielding investors from the fury.
Dramatic metaphors aside, we truly live in unprecedented times. Risk lurks everywhere.
List is endless. Unstable geopolitics. Sticky inflation. Recession expectations. Unprecedented deepening of yield curve inversion. Unfinished regional banking crisis. Weak manufacturing. Tightening financial conditions. Extremely divisive global politics, to just name a few.
Despite severe headwinds, US equity markets are roaring. YTD, S&P is up +15% and Nasdaq is up +32%.
At the start of 2023, the consensus was for US equities to be in doldrums dragged down by recession. Halfway through the year, markets are at the cusp of one of the best first half for US equity markets in twenty years.
This is among the narrowest and top-heavy rally ever. Only a sliver of stocks - precisely seven of them - defines this optimism. This paper will refer to these as the Super Sevens.
These are the biggest members of the S&P 500 index. Super Sevens are Amazon, Apple, Google, Meta, Microsoft, Nvidia, and Tesla.
This paper argues that the Super Sevens will deliver above market returns in the short term as investors seek safe haven from a vast array of macro risks.
The paper articulates a case study to demonstrate the use of beta hedging to extract alpha from holding long positions in Super Sevens and hedging them against sharp reversals using CME Micro E-Mini S&P 500 index futures ("CME Micro S&P 500 Futures").
THE RISE AND RISE OF SUPER SEVENS
Super Sevens have an outsized impact as S&P 500 is a market weighted index.
Merely five of these seven form 25% of the S&P 500 market capitalisation. At $2.9 trillion in market capitalisation, Apple is greater than all of UK’s top 100 listed companies put together.
If that were not enough, Apple's market capitalisation alone is greater than the aggregate market capitalisation of all the firms in the Russell 2000 index.
Nvidia has been soaring on hopes of AI driven productivity gains. On blow out revenue guidance, it has rallied $640 billion in market cap YTD. That increment alone is larger than the combined market cap of JP Morgan & Bank of America the two largest banks in the US.
The heatmap summarises analyst targets & technical signals on pathway for prices ahead:
In part 2 of this paper, Mint will cover the detailed analyst price forecasts, technical signals and summary narratives covering value drives and intrinsic risk factors.
WHAT DRIVES INVESTOR CONCENTRATION INTO THE SUPER SEVENS?
As reported in the Financial Times last week, two broad market trends appear to have fed into this investor concentration.
First, Passive investing. When funds merely deliver the performance of an index by replicating its composition, the higher the index weights, the more these passive funds buy into these names.
Second, ESG investing. Rising push towards ESG has forced investment into tech and away from carbon-heavy sectors such as energy.
Collectively, this has resulted in all types of investors – active, passive, momentum, ESG- all going after the same names.
Question is, what happens now? Will the broader market catch up with the Super Sevens? Or will the Super Sevens suffer a sharp pullback?
That depends on the broader US economy. Will it have a hard landing, soft landing, or no landing at all?
Given market expectations of (a) resilient earnings capacity, and (b) solid growth potential among Super Sevens, we expect that in the near to mid-term the Super Sevens will continue to outperform the broader market.
In ordinary times, investors could have simply established long positions in Super Sevens and wait to reap their harvests. However, we live in unprecedented times.
WE LIVE IN TRULY UNPRECEDENTED TIMES
Risks abound but no signs of it in equity markets. Historically, geopolitical instability, tightening financial conditions, and a deeply inverted curve could have led to crushing returns in the US equity markets. Not this time though.
Peak concentration
As mentioned earlier, bullishness in equity markets can be vastly attributed to just the Super Sevens. These seven have delivered crushing returns rising between 40% and 192% YTD. The S&P 500 index is market cap weighted. Super Sevens represent the largest companies in the index by market cap and their stellar performance has an outsized impact on the index.
Is this a bull run or a bear market clouded by over optimism among Super Sevens?
Deeply inverted yield curve
In simple words, it costs far more to borrow for the near term (2 year) relative to the borrowing for long term (10-year). The US Treasury yield curves have been inverted for more than a year now. The difference between the 2-Year and 10-Year treasuries is at its widest level since the early 1980s.
Inversion in yield curve has historically been a credible signal of recession ahead. When bonds with near term duration yield higher rates than those with longer-dated expiries, this precedes trouble in the economy.
Recession. What recession?
This period might go into the record books for the most long-awaited recession that is yet to come. For the last 12 months, experts have been calling for recession to show up in 3 months.
While manufacturing sector seems feeble, labour market remains solid. Corporate balance sheets are robust. Consumer finances and consumer confidence are in good health.
The VIX remains sanguine while the only fear indicator that appears unsettled is the MOVE index which indicates volatility in the bond markets. After having spiked earlier in the year, the MOVE is starting to soften as well.
BETA HEDGING FOR PURE ALPHA
In times of turbulence, risk management is not an afterthought but a necessity.
Hedge delivers the edge. When there are ample arguments to be made for bullish and bearish markets, taking a directional position can be precarious.
This paper posits Super Sevens holdings be hedged with CME Micro S&P 500 Futures. Hedging single stocks is nuanced. The stocks and the index do not always move in tandem. A given stock may be more volatile or less volatile relative to the benchmark. Beta is the sensitivity of the stock price relative to a benchmark.
Beta is computed from daily returns over a defined historical period. Stocks with high Beta move a lot more than the underlying index. Stocks that move narrowly relative to its underlying benchmark exhibits low Beta.
Beta hedging involves adjusting the notional value of a stock price based on its beta. Using beta-adjusted notional, hedging then involves taking an offsetting position in an index derivative contract to match the notional value.
TradingView publishes beta values computed based on daily returns over the last 12 months. The following table illustrates the beta-adjusted notional for the Super Sevens based on the last traded prices as of close of market on June 16th.
Beta hedging using CME Micro S&P 500 Futures enables investors to precisely scale their portfolio exposures to the index. A small contract size enables investors to manage risks with finer granularity.
CME allows conversion of micro futures into a classic E-mini futures position, and vice versa. Round the clock liquidity combined with tight spreads and sizeable open interest across the two front contract months, investors can enter and exit the market at ease.
BETA-HEDGED TRADE SET UP
In unprecedented times like today, markets may continue to rally or come crashing. To harness pure alpha, this paper posits a spread with long positions in Super Sevens hedged by a short position in CME Micro S&P 500 Futures expiring in September 2023.
This trade set-up gains when (a) Super Sevens rise faster than the S&P 500, or (b) Super Sevens suffers drop in value but falls lesser relative to S&P 500, or (c) Super Sevens gain while S&P 500 falls.
This trade setup loses when (a) Super Seven falls faster than S&P 500, or (b) S&P 500 rises faster than Super Seven, or (c) S&P 500 rises while Super Sevens pullback
Each CME Micro S&P 500 Futures has a multiplier of USD 5. The September contract settled on June 16th at 4453.75 implying a notional value of USD 22,269 (4453.75 * USD 5).
Effective beta hedge requires that notional of the hedging trade is equivalent to the beta-adjusted notional value of single stock. Given the beta-adjusted notional value of USD 2,561 for single shares in Super Sevens and the notional value for each lot of CME Micro S&P 500 Futures at USD 22,269, the spread trade requires:
a. A long position in 26 shares each across all the Super Sevens translating to a beta-adjusted notional of USD 66,576.
b. Hedged by a short position with 3 lots of CME Micro S&P 500 Futures which provides a notional exposure of USD 66,807.
The following table illustrates the hypothetical P&L of this spread trade under various scenarios:
MARKET DATA
CME Real-time Market Data helps identify trading set-ups and express market views better. If you have futures in your trading portfolio, you can check out on CME Group data plans available that suit your trading needs tradingview.com/cme/.
DISCLAIMER
This case study is for educational purposes only and does not constitute investment recommendations or advice. Nor are they used to promote any specific products, or services.
Trading or investment ideas cited here are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management or trading under the market scenarios being discussed. Please read the FULL DISCLAIMER the link to which is provided in our profile description.
Dramatic metaphors aside, we truly live in unprecedented times. Risk lurks everywhere.
List is endless. Unstable geopolitics. Sticky inflation. Recession expectations. Unprecedented deepening of yield curve inversion. Unfinished regional banking crisis. Weak manufacturing. Tightening financial conditions. Extremely divisive global politics, to just name a few.
Despite severe headwinds, US equity markets are roaring. YTD, S&P is up +15% and Nasdaq is up +32%.
At the start of 2023, the consensus was for US equities to be in doldrums dragged down by recession. Halfway through the year, markets are at the cusp of one of the best first half for US equity markets in twenty years.
This is among the narrowest and top-heavy rally ever. Only a sliver of stocks - precisely seven of them - defines this optimism. This paper will refer to these as the Super Sevens.
These are the biggest members of the S&P 500 index. Super Sevens are Amazon, Apple, Google, Meta, Microsoft, Nvidia, and Tesla.
This paper argues that the Super Sevens will deliver above market returns in the short term as investors seek safe haven from a vast array of macro risks.
The paper articulates a case study to demonstrate the use of beta hedging to extract alpha from holding long positions in Super Sevens and hedging them against sharp reversals using CME Micro E-Mini S&P 500 index futures ("CME Micro S&P 500 Futures").
THE RISE AND RISE OF SUPER SEVENS
Super Sevens have an outsized impact as S&P 500 is a market weighted index.
Merely five of these seven form 25% of the S&P 500 market capitalisation. At $2.9 trillion in market capitalisation, Apple is greater than all of UK’s top 100 listed companies put together.
If that were not enough, Apple's market capitalisation alone is greater than the aggregate market capitalisation of all the firms in the Russell 2000 index.
Nvidia has been soaring on hopes of AI driven productivity gains. On blow out revenue guidance, it has rallied $640 billion in market cap YTD. That increment alone is larger than the combined market cap of JP Morgan & Bank of America the two largest banks in the US.
The heatmap summarises analyst targets & technical signals on pathway for prices ahead:
In part 2 of this paper, Mint will cover the detailed analyst price forecasts, technical signals and summary narratives covering value drives and intrinsic risk factors.
WHAT DRIVES INVESTOR CONCENTRATION INTO THE SUPER SEVENS?
As reported in the Financial Times last week, two broad market trends appear to have fed into this investor concentration.
First, Passive investing. When funds merely deliver the performance of an index by replicating its composition, the higher the index weights, the more these passive funds buy into these names.
Second, ESG investing. Rising push towards ESG has forced investment into tech and away from carbon-heavy sectors such as energy.
Collectively, this has resulted in all types of investors – active, passive, momentum, ESG- all going after the same names.
Question is, what happens now? Will the broader market catch up with the Super Sevens? Or will the Super Sevens suffer a sharp pullback?
That depends on the broader US economy. Will it have a hard landing, soft landing, or no landing at all?
Given market expectations of (a) resilient earnings capacity, and (b) solid growth potential among Super Sevens, we expect that in the near to mid-term the Super Sevens will continue to outperform the broader market.
In ordinary times, investors could have simply established long positions in Super Sevens and wait to reap their harvests. However, we live in unprecedented times.
WE LIVE IN TRULY UNPRECEDENTED TIMES
Risks abound but no signs of it in equity markets. Historically, geopolitical instability, tightening financial conditions, and a deeply inverted curve could have led to crushing returns in the US equity markets. Not this time though.
Peak concentration
As mentioned earlier, bullishness in equity markets can be vastly attributed to just the Super Sevens. These seven have delivered crushing returns rising between 40% and 192% YTD. The S&P 500 index is market cap weighted. Super Sevens represent the largest companies in the index by market cap and their stellar performance has an outsized impact on the index.
Is this a bull run or a bear market clouded by over optimism among Super Sevens?
Deeply inverted yield curve
In simple words, it costs far more to borrow for the near term (2 year) relative to the borrowing for long term (10-year). The US Treasury yield curves have been inverted for more than a year now. The difference between the 2-Year and 10-Year treasuries is at its widest level since the early 1980s.
Inversion in yield curve has historically been a credible signal of recession ahead. When bonds with near term duration yield higher rates than those with longer-dated expiries, this precedes trouble in the economy.
Recession. What recession?
This period might go into the record books for the most long-awaited recession that is yet to come. For the last 12 months, experts have been calling for recession to show up in 3 months.
While manufacturing sector seems feeble, labour market remains solid. Corporate balance sheets are robust. Consumer finances and consumer confidence are in good health.
The VIX remains sanguine while the only fear indicator that appears unsettled is the MOVE index which indicates volatility in the bond markets. After having spiked earlier in the year, the MOVE is starting to soften as well.
BETA HEDGING FOR PURE ALPHA
In times of turbulence, risk management is not an afterthought but a necessity.
Hedge delivers the edge. When there are ample arguments to be made for bullish and bearish markets, taking a directional position can be precarious.
This paper posits Super Sevens holdings be hedged with CME Micro S&P 500 Futures. Hedging single stocks is nuanced. The stocks and the index do not always move in tandem. A given stock may be more volatile or less volatile relative to the benchmark. Beta is the sensitivity of the stock price relative to a benchmark.
Beta is computed from daily returns over a defined historical period. Stocks with high Beta move a lot more than the underlying index. Stocks that move narrowly relative to its underlying benchmark exhibits low Beta.
Beta hedging involves adjusting the notional value of a stock price based on its beta. Using beta-adjusted notional, hedging then involves taking an offsetting position in an index derivative contract to match the notional value.
TradingView publishes beta values computed based on daily returns over the last 12 months. The following table illustrates the beta-adjusted notional for the Super Sevens based on the last traded prices as of close of market on June 16th.
Beta hedging using CME Micro S&P 500 Futures enables investors to precisely scale their portfolio exposures to the index. A small contract size enables investors to manage risks with finer granularity.
CME allows conversion of micro futures into a classic E-mini futures position, and vice versa. Round the clock liquidity combined with tight spreads and sizeable open interest across the two front contract months, investors can enter and exit the market at ease.
BETA-HEDGED TRADE SET UP
In unprecedented times like today, markets may continue to rally or come crashing. To harness pure alpha, this paper posits a spread with long positions in Super Sevens hedged by a short position in CME Micro S&P 500 Futures expiring in September 2023.
This trade set-up gains when (a) Super Sevens rise faster than the S&P 500, or (b) Super Sevens suffers drop in value but falls lesser relative to S&P 500, or (c) Super Sevens gain while S&P 500 falls.
This trade setup loses when (a) Super Seven falls faster than S&P 500, or (b) S&P 500 rises faster than Super Seven, or (c) S&P 500 rises while Super Sevens pullback
Each CME Micro S&P 500 Futures has a multiplier of USD 5. The September contract settled on June 16th at 4453.75 implying a notional value of USD 22,269 (4453.75 * USD 5).
Effective beta hedge requires that notional of the hedging trade is equivalent to the beta-adjusted notional value of single stock. Given the beta-adjusted notional value of USD 2,561 for single shares in Super Sevens and the notional value for each lot of CME Micro S&P 500 Futures at USD 22,269, the spread trade requires:
a. A long position in 26 shares each across all the Super Sevens translating to a beta-adjusted notional of USD 66,576.
b. Hedged by a short position with 3 lots of CME Micro S&P 500 Futures which provides a notional exposure of USD 66,807.
The following table illustrates the hypothetical P&L of this spread trade under various scenarios:
MARKET DATA
CME Real-time Market Data helps identify trading set-ups and express market views better. If you have futures in your trading portfolio, you can check out on CME Group data plans available that suit your trading needs tradingview.com/cme/.
DISCLAIMER
This case study is for educational purposes only and does not constitute investment recommendations or advice. Nor are they used to promote any specific products, or services.
Trading or investment ideas cited here are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management or trading under the market scenarios being discussed. Please read the FULL DISCLAIMER the link to which is provided in our profile description.
Full Disclaimer - linktr.ee/mintfinance
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