Navigating Frothy US Equities with S&P Spreads

Navigating frothiness in US equities requires both caution and tact. With the S&P 500 nearing its all-time high amid flashing recession signals, investors must be vigilant with volatility during upcoming earnings season, driven by outsized expectations.

This paper explores the persistent recession indicators and forces at play during upcoming earnings. The paper posits a spread trade using CME’s Micro E-Mini futures (Long S&P 500 and Short Russell 2000) to maintain upside potential with reduced downside risk.


On Friday, the PCE Price Index (Fed’s preferred gauge) showed inflation cooling to 2.6% in May, in line with expectations. Price pressures are slowly abating.

Numbers aside, the broader economic landscape presents a complex picture.

Signals from the job market point to unemployment claimants at a record high for the past two and a half year with job openings shrinking drastically. Personal earnings were higher than anticipated in May (0.5% vs 0.4%), but spending was below expectations. Consumers are being more cautious. Mint Finance covered these nuances in a previous paper.

Housing is flashing weakness as new housing starts hit a four-year low in May. Soaring prices and steep mortgage rates are weighing on demand.

The Fed’s policy path remains unconfirmed. However, consensus point to a rate cut as early as September. Even if that happens, rates are expected to decline gradually.

Source: CME FedWatch

Despite risk of recession, the S&P 500 has had an exemplary showing this year, trading near their all-time high. YTD performance of 15% in 2024 has been far higher than the 74-year average of 4%.

Yet, the performance has been increasingly top-heavy. Nvidia, Apple, and the rest of the tech titans have contributed much of the gains in the broad S&P500 index as it is market cap weighted. The index is heavily reliant on and sensitive to the performance of these mega-caps.

The equal-weighted S&P 500 index is up only by 4% in sharp contrast. The spread between the S&P 500 and its equal-weighted counterpart is near its highest point since 2008. The spreads between the S&P 500 and both the Russell 2000 and S&P Midcap indexes have reached multi-decade highs.

Outperformance was re-affirmed after the recent earnings season. Mega-caps crushed EPS and revenue expectations and reported phenomenal guidance while other stocks, especially utility and energy sector reported revenue and EPS figures below estimates according to FactSet report.

Rallies in mega-cap stocks are being driven by idiosyncratic tailwinds, such as advancements in AI. Meanwhile, slowing consumer spending in the US is raising concerns for the broader market.


According to FactSet, Q1 earnings season was positive. Only 19% of firms reported earnings below expectations. Actual average EPS YoY growth for the index was 5.9% (above 3.4% expected as of March 31).

Frothiness in the equity market is palpable. Consistent outperformance by mega caps is baked into investor expectations. Strong earnings are already factored into prices, as evidenced by the S&P 500's P/E ratio of 28.38x (far higher than the 10-year average of 20x translating to a 42% above average earnings expectations). Average P/E ratio in the best performing tech sector is even higher at 37.47x.

Even minor shortfalls in guidance or revenue/earnings can lead to significant corrections in such a climate. The FactSet reports that 31.8% of firms which beat earnings EPS estimates by up to +5% saw average price decline of -0.9%.

Source: FactSet Research

In fact, overall, positive earnings only drove a 0.9% increase in price (1% 10Y historical average) while a negative earnings report led to 2.8% drop (-2.3% 10Y historical average).

Source: FactSet Research

Market frothiness elevates risk of a sharp price correction in single names during Q2 earnings. Analysts are concerned as expectations for Q2 EPS YoY growth have been lowered from 9% on 31/March to 8.8% as of 22/June.

Despite this, mega-caps remain in solid position. Robust demand for AI, buoyant advertising revenue, globalized revenue streams, and substantial market dominance have positioned them to continue growing at a disproportionate rate.

In case the upcoming Q2 results pan out similarly to Q1 in favor of mega-caps, the S&P 500 will continue to outperform the broader market indices.


The S&P 500, with its high concentration of mega-cap stocks, is likely to perform better than broader market indices in the coming earnings season. However, recession signals are also flashing.

The S&P 500 does not perform well during recessions. Over the last four recessions, it has declined an average of -14%. Comparatively the spread between S&P 500/Russell 2000 spread has increased 1.7%.

The S&P 500/Russell 2000 spread has also outperformed during the six-month preceding recessions.

Given the S&P 500-Russell 2000 spread's historical outperformance during recessions, a spread position presents less downside risk compared to an outright long position in the S&P 500.

This strategy also maintains a bullish outlook on the top-heavy S&P 500's potential to outperform in the upcoming season.

Moreover, the spread trade preserves the upside potential in the ongoing rally, as its performance has been comparable to an outright long position in the S&P 500.

A view on the spread between the S&P 500 and Russell 2000 can be expressed using CME Micro E-Mini Equity futures. At 1/10th the size of the full-size E-mini futures, the Micro contracts allow for smaller trades with more granular exposure.

A long position in the Micro E-Mini S&P 500 futures expiring in September (MESU2024) can be offset by a short position on 2 x Micro E-Mini Russell 2000 futures expiring in September (M2KU24). This position is highly margin-efficient as CME offers margin credit for this spread.

Hypothetical trade set up in summary requires entry at 2.69x, with a target at 2.78x coupled with stop loss at 2.6x.

The simulated payoffs are described below.


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