S&P 500: Expensive but Not Overpriced

CME: E-Mini S&P 500 ( ES1! ), S&P Technology Sector ( XAK1! )
These days, the S&P 500 is not behaving like a well-diversified stock market index. The “Magnificent Seven”, which includes Nvidia NVDA , Apple AAPL , Tesla TSLA , Microsoft MSFT , Google GOOGL , Meta META and Amazon AMZN , is up roughly 60% year-to-date. These 7 tech stocks now represents ~30% of the entire S&P 500 index.

Meanwhile, the remaining 493 companies in the S&P 500 are up only 3% YTD. Altogether, the S&P 500 is up 15.8% YTD as of June 15th.

The tech-heavy Nasdaq 100, which includes all the Magnificent Seven, is up 39.5% YTD. The Dow Jones Industrial Average, with only one of the seven, AAPL , in its components, had a very disappointing return of 4.0% YTD.


What sparks the recent market rally is OpenAI’s ChatGPT. Its November 20th launch ignited a global sensation in Artificial Intelligence. By now, the entire US stock market is being held up by the red-hot AI momentum.

S&P 500 Performance by Sector
Of the 11 S&P select sectors, I found that only Technology has a decent 12-month performance. Three other sectors have low single-digit return, and the rest are in the red. (Data source: S&P Global, 12-month returns as of May 31st, 2023).
• Consumer Discretionary: -0.83%
• Consumer Staples: 0.22%
• Energy: -8.23%
• Financials: -8.55%
• Real Estate: -15.47%
• Health Care: -1.71%
• Industrials: -4.15%
• Materials: -10.69%
• Technology: 18.16%
• Utilities: --9.96%
• Communication Services: 4.47%
• S&P 500: 1.15%

Once again, data confirms that the recent stock market rally is exclusively reserved for the tech stocks. Investing in the S&P 500 is like holding an outstanding tech-sector fund on one hand, and a sucker fund of poorly-performing stocks on the other.

Statistical Analysis of the S&P 500
Diving deeper into the S&P, I found that its 3-year mean is 4027.2 as of June 15th. The standard deviation during this period is 395.6. We know from probability distribution that the time series of price data falls inside plus or minus one standard deviation approximately 33% of the time. This corresponds to the index range of 3632 and 4423.

Data trend shows that whenever the index broke away from this boundary, it had the tendency of getting pulled back in. This fits the rule of mean reversion, as seen below:
• The S&P broke through 4400 in August 2021 and reached its record height at 4800 in January 2022. Over the next four months, it plunged 1,000 points, or -22.8%.
• The S&P fell below 3600 in September 2022. It rebounded after it crossed the -1 STD line and regained 24% as of last Friday.

S&P 500 closed at 4,453.75 on June 15th, which placed it 30 points above the +1 STD line. It is approaching “expensive” level from the historical perspective. But will it trend down from here? I seriously doubt it.

The AI momentum could carry the stock market index much higher. We are at an early stage to even access how AI could revolutionize our world. Waves of technological breakthroughs and new applications would continue to fire up investor sentiment.

Recent resolution of the Debt Ceiling Crisis and the Fed pausing rate hikes in June are also strong tailwinds which have helped lift stock market valuation.

If the index reaches the +2 STD line, at 4818.43, we could argue that it marks a turning point. We shall understand that this is not a broad-based stock market rally. The consequence of high inflation and high interest rates would weigh on company profitability for many months to come. At lofty valuation, the Magnificent Seven could no longer carry the weight of 493 mediocre companies. The S&P could come crushing down under its own weight.

Hedging the Risk of a Tech Sector Fallout
In my opinion, while the S&P 500 is expensive, it is not yet overpriced. We could still ride the AI wave by holding stocks or a long position in the stock index futures. I am not particularly concerned whether you call this a new bull market or a bear market rally.

However, the entire stock market is overly concentrated in the tech sector. A handful of chip manufacturers, namely Nvidia and TSMC, holds systemic risk. If their production is threatened by geopolitical conflicts, the entire stock market could crash.

Nvidia sees its share price doubled this year, and has a ridiculous price earnings ratio of 222. Its massive $1 trillion market valuation has been built upon the huge promise of AI. Any negative news on Nvidia would have a disproportionally large impact on the S&P.

To hedge the risk of AI bubble going busted, I am exploring a spread trade with long S&P index futures ES and short Technology Select Sector futures $XAK.


Since the Magnificent Seven accounts for 30% of S&P 500 market value, I am considering a 10:3 spread ratio. By measure of contract notional value, for every $100,000 in ES long positions, short XAK by $30,000.
• ESU3 is quoted 4,459 on June 15th. Its notional value is five times the index, or $222,950. Each contract requires a margin of $11,200;
• XAKU3 is quoted 1761.40 on the same day. Its notional value is 100 times the index, or $176,140. Each contract requires a margin of $9,500.
• The spread trade would consist of 4 long ES futures and 1 short XAK futures.

If an investor already had investment in S&P component stocks, he could hold on to them. However, the investor could consider shorting XAK futures to hedge the downside risk.

For every $600K in stock investment, hedge it with 1 short XAK position. The logic of this trade is that if the tech sector gets into trouble, the short XAK trade would protect the value of long stock positions.

Happy trading.

Disclaimers
*Trade ideas cited above are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management under the market scenarios being discussed. They shall not be construed as investment recommendations or advice. Nor are they used to promote any specific products, or services.

CME Real-time Market Data help identify trading set-ups and express my market views. If you have futures in your trading portfolio, you can check out on CME Group data plans available that suit your trading needs www.tradingview.com/cme/