Jim Iuorio, for CME Group
AT A GLANCE
- The Nasdaq continues its rally from March 2020 lows, but remains closely correlated to movements of a handful of companies
- Traders have increasingly used Micro Nasdaq futures contracts as a hedge as the tech rally carried on
Since putting in a pandemic low on March 23, 2020, Nasdaq 100 futures have posted a stunning 125% rally in the subsequent 17 months, making an all-time high on July 26, 2021.
This gain far outpaces the 100% rally of the broader S&P 500. The Nasdaq’s out performance has been generally attributed to several factors. The primary reason given for the initial gain was a belief that the pandemic and post pandemic economy would rely heavily on technology as work from home and remote communication became paramount.
Tech’s Relationship to Rates
There was also the issue of interest rates. Technology companies tend to have a strong inverse correlation to interest rates because of commonly used discounted cash flow models. In short, the lower interest rates are today the more attractive the growth and technology sector becomes because of optimistic projections of future earnings.
Of course, this phenomenon occurs in all stocks to some extent, but it’s much more pronounced in technology. There is another characteristic of this rally that has drawn some attention. The biggest beneficiaries have been a select few technology behemoths. At current valuations only seven companies make up almost 50% of the market cap of the entire Nasdaq index. The largest six U.S. companies by market cap and six out of the top eight global companies are among those same Nasdaq technology companies. The overall index is now more closely correlated to the price movements of a handful of companies than it has been in the past.
The rally has not been without some significant hurdles. In February 2021 the Nasdaq suffered a 12% correction and again in April it lost 8% of its value. These losses occurred at or near the week when much of the technology sector reported earnings. This was interesting in that the reported earnings of the tech giants were somewhere between good and really good. Perhaps the weakness that followed was an indication of a crowded long trade or perhaps it was due to the fact that interest rates were rising concurrently in both instances.
Since April, however, the story in interest rates has changed. The collapse of several high- profile commodities has taken some wind out of the inflation narrative and has allowed the 10-year yield to go from a high of 1.7% in April to a current level of 1.2%. This development appears to be supportive of the Nasdaq in relation to the other indexes as pandemic fears rise.
Headlines from the U.K. regarding a resumption of travel restrictions coupled with an alarming rise of new variants of COVID-19 have challenged the assumption of a smooth reopening. The question traders are asking themselves is will a backtrack of the reopening trade boost the Nasdaq as it did in the early stages of the pandemic? The next few weeks of pandemic developments could create volatility in the sector.
Alongside the massive rally in tech stocks has been increases in trading volumes of CME Nasdaq futures, particularly the micro contracts. The micro e-mini contracts seem to reflect the growing involvement of retail traders with a desire to take a more active role in their financial management.
The Micro Nasdaq contract is 1/10th the size of the standard E-mini contract and currently has a notional value around $29,000. Each contract requires $1600 in maintenance margin for an 18/1 leverage ratio. This allows opportunities for risk hedging or directional expression with minimal capital tied up. The average daily volumes in Nasdaq micros has grown to near 1,000,000 contracts per day and the contract has shown impressive around the clock liquidity.
With how widely held the biggest names in technology are and how correlated they are to the Nasdaq, micros have become a reasonable hedge against longer term equity holdings especially during these times of potential market turbulence.