Financials Gain With Tech In PainWhen central banks raise rates, financial sector outperforms. That is until credit crumbles by which time all bets are off.
As federal funds rates spike and stay elevated for longer, lending rates will climb higher relative to deposit rates. Net Interest Margin ("NIM") which is the difference between lending and borrowing rates continues to favour financial services firms.
Inflation while softening remains high in developed and emerging markets. Hopes of Fed pivot on rates is fading as inflation is starting to spike again in some countries. Central banks on either side of the Atlantic are determined to tame it down.
Continued rate hikes push economies into recession, crush consumer demand while increasing credit (corporate & personal) defaults. At that stage, even the financial industry (“financials”) starts to feel the pinch. But growth and tech stocks will be hurt even more. These stocks will plummet as present values of future distant profits get discounted at higher rates.
As financials gain from attractive NIMs, growth stocks meanwhile are likely to get hammered from elevated rates. This case study articulates a spread trade to harness yields from these anticipated market moves.
Investors with portfolio exposure to S&P Financial Select Sector Index ("Financials Index") can participate in industry's outperformance. This index provides exposure to banks, mortgage firms, consumer financial firms, capital markets and insurance firms, among others.
A long position in CME E-Mini Financial Select Sector Futures and a short position in CME Micro E-Mini Nasdaq-100 Index Futures will deliver >2.7x reward to risk ratio.
HISTORICAL NEXUS BETWEEN TECH-HEAVY NASDAQ & FINANCIALS INDEX
Over the last 10 years, the ratio of the Financials Index relative to Nasdaq-100 touched a high of 0.0917 in July 2013 and a low of 0.0342 in November 2020. The ratio rises when financials outperform Nasdaq.
The ratio hovered around 0.072 on average from 2013 until the onset of pandemic linked monetary stimulus. It plunged when the monetary policy taps were let loose. Valuations of tech, high-growth, non-profitable firms soared relative to staid financials.
However, with QE substituted by QT i.e., from monetary easing to tightening, financials are set to fight back.
Frail demand with layoffs is the uncertain path ahead for tech. In contrast, financials appear poised with resilient balance sheets to swing the ratio back in its favour.
DEMYSTIFYING S&P FINANCIAL SELECT SECTOR INDEX
The Financials Index is market cap weighted and rebalanced quarterly. As of end February 2023, there were sixty-seven companies in total with the top-10 representing 53% of the index. Top-10 index constituents by weight and their 12-month price targets are summarised below.
Price targets (PT) for the top-10 point to an average appreciation of 12%. The average of maximum PT among the top-10 delivers a spectacular gain of 29%. However, the average of minimum PT among the same group shows a drop of 8%. Clearly analyst targets are skewed towards a healthy upside gain with limited downside risk.
FEDERAL FUNDS RATE TO STAY HIGHER FOR LONGER
In speaking to Barron’s, Brian Moynihan, CEO of Bank of America said that the Fed is going to have to leave the rates at a higher structure than people may believe. The Fed were late to the game, and they have got to keep rates high for long until it works through the system.
ELEVATED RATES HURTING DEMAND BUT INVESTORS REMAIN EERILY BULLISH
Tech sector is feeling the heat of melting demand. Revenues of S&P 500 tech firms is expected to grow only 2% this year. It is the slowest since 2016 as per Bloomberg Intelligence.
Q4 earnings have been sending worrying signals for the largest tech companies. Earnings from Apple, Microsoft, Alphabet, Amazon & Meta missed estimates by 8% on average, as per Bank of America.
Despite cracks in Q4 earnings, investors’ enthusiasm for tech stocks remains bubbly. Nasdaq is up 13% this year.
Rising share prices coupled with shrinking earnings estimates is pushing Nasdaq valuations into lofty zone. The Nasdaq is now priced at 24-times one-year forward earnings, compared to an average of 20-times over the last decade. Overpriced by 20% based on historical standards.
In contrast, financials price-earnings ratios, as represented by Financial Select Sector SPDR ETF is at a humble14.5-times. Every dollar of earnings per year requires $14.5 in financials compared to $24 in Nasdaq. In theory, the Nasdaq is 66% more expensive than financials.
Bullish markets this year has pushed Nasdaq stocks well ahead of price targets. This phenomenon might be the result of a bear market rally or short covering or rising retail participation or all of them. Consequently, ratio of financials to Nasdaq has slumped 9% so far this year setting the scene for an attractive spread trade entry.
TRADE SET UP
As central banks are determined to keep inflation down by keeping rates higher for longer, this paper demonstrates a long position in CME E-Mini Financial Select Sector Futures expiring in June 2023 (“financial futures”) and a short position in CME Micro E-Mini Nasdaq-100 Index Futures expiring in June 2023 (“Micro Nasdaq”) will deliver >2.7x reward to risk ratio.
Spreads require that the notional values of each leg of the trade to be identical. Each financial futures provides an exposure to $250 x S&P Financial Select Sector Index. Meanwhile, each Micro Nasdaq provides an exposure of $2 x Nasdaq-100 Index.
As of March 3rd, financial futures expiring in June 2023 settled at 446.4 while the Micro Nasdaq settled at 12,446.50.
Balancing each leg of the trade requires 2-lots of financial futures (2 lots x $250 x 446.4 = $223,200) and 9-lots of Micro Nasdaq (9 lots x $2 x 12,446.50 = $224,037).
Entry: 0.0359 (446.4/12,446.5)
Target: 0.0405
Stop: 0.0342
Profit at Target: $ 28,800
Loss at Stop: $10,350
Reward-to-Risk Ratio: >2.7x
MARKET DATA
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