S&P500 Becoming a Marionette for MAGA?

Introduction

Trading ideas and strategies are heavily affected by the decision makers’ overall view on the market. One of the main indicators of the US market strength is the S&P500 index, which is praised for its broad scope compared to other indices such as The Dow Jones Industrial Average. Many investors use this index as an evaluation tool for their performance, seeking to realize alpha in excess of the index’s returns. Furthermore, the S&P500 index has historically been closely watched by the FED to spot heat in asset prices.

In this article, we will look at the S&P500 with scrutiny in regard to its accuracy at portraying the market as a whole. This potential threat of its inaccuracy arises from the increasingly dominating tech companies with greatly expanding market capitalizations. While zooming-in on the tech sector’s impact on the S&P500, 4 stocks proved to especially stand-out with their importance. These stocks are Microsoft, Amazon, Alphabet, and Apple, which we collectively abbreviate as MAGA (notice that G stands for Google whose parent company is now called Alphabet). The reasons behind MAGA’s importance are numerous, however, at their core, stands its 12.78% share of the S&P500 index (as of 21/11/2018). This is a worryingly high share of the S&P500 being consumed by four stocks in one sector, given that fact that the role of the index is to portray the US market as a whole.

While tech stocks are not new leaders in the S&P500, as we have previously seen IBM and AT&T domination in S&P500, the dominance of these four tech stocks in the S&P500 is new to the markets. The assumption that S&P500 tracks Corporate America’s energy relies on strong interactions that S&P500 companies have with all participants of the US Economy. But, MAGA stocks’ synergy of creating business opportunities to small and mid-sized companies are limited when compared to former S&P500 leading stocks such as Walmart.

Tech Stocks vs. The Market

Tech companies have historically outpaced the market, even without overly bullish sentiments about their stocks. The reasons lie in these companies’ nature, as it is these types of companies that experience the highest growth if successful which goes in par with attaining high market shares. This is due to the relative ease with which tech companies can expand their customer bases, as in many cases obtaining new customers is as easy as an email signup, especially in the case of rapidly expanding web/cloud services. Activity in this sector has proved to be especially successful for Amazon, with their web services (AWS) accounting for 55% of their Q2 2018 operating profits, despite only making up 12% of the company’s net sales. Furthermore, the dynamics of the sector make companies within it be prone to either failure or domination. These dynamics do not allow companies to slack behind, for example, if a startup launches a new product to the market, by the time it can be replicated the company already moves onto the next new development, making latecomers have an especially hard time catching up.

The aforementioned aspects of the tech industry make it play by its own rules when it comes to valuations, and hence P/E ratios and other indicators alike. Privately-held rising startups, or so called “unicorns” often reach valuations of much above a billion dollars before ever turning in a profit. Furthermore, it is completely normal for companies in the tech industry to have their P/E ratios float in the hundreds, or in many cases not even apply as the number would be negative. These characteristics of tech stocks can be attributed to the fact that investors operating in the sector are more comfortable on betting on innovative ideas which are only projected to bring profits in the not-so-near future.

MAGA vs. S&P500

As established in the previous paragraphs, tech stocks tend to play by their own rules. However, the stock collective we defined earlier as MAGA has major influence over important indices used to determine the state of the overall economy, hence a question arises: can their inclusion in such indices cloud our perspective of the market as a whole?

While “cloud” is too strong of a word to immediately answer the question with a yes or no, in the following part of the article we aim to give you data with which you can make your own conclusion on how to look at an index like the Standard & Poor’s 500 keeping in mind MAGA stock movement and influence.

In order to do this, we compiled 3 indices to compare, all indexed to a common starting point of 100 on the last day of 2017. First one is the usual S&P500 market cap, second is the S&P500 without MAGA stocks market cap, and third is MAGA stocks market cap, all on a monthly basis.

A clear difference can be seen in the movement of MAGA stocks in comparison to the more bearish market represented by the S&P500. This difference is great enough to cause the S&P500 to show significantly greater gains, than its non-MAGA counterpart. This proves just how much significance the movement of those 4 stocks has for the S&P500. Due to this, concerns arise whether the S&P500 can be accurately used to assess the health of the market as a whole. While the S&P500 without MAGA still moves in the same pattern, as there are then 496 firms of the S&P500 left in it, it is an alarming observation that this slightly altered version of the original 500 can show a significantly more bearish image of the market.

The June to September MAGA rally creates a significant dispersion in the two S&P based indices, but that gap has been closing after MAGA stocks took a bigger hit than the rest of the market in October. This faster-than-the-market drop of value in MAGA stocks seems to be currently continuing throughout November, which could mean the effect of MAGA on the S&P500 will reverse from positive to negative, and the S&P500 without MAGA will outperform its original counterpart. With such adverse differences in the performance of MAGA compared to the rest of the market, we wonder, is it time for investors to start paying more attention to this stock collective and its impact?

The answer to this question only leans towards a ‘yes’ when looking at MAGA stocks’ high volatility, which can be shown by their increased β in the period analysed (31/12/2017 to 31/10/2018). The β of the MAGA index in this period comes out to 1.78 which is higher than all of the individual MAGA stock 3Y Betas except for Amazon placing at 1.94. This proves that the increased volatility in those stocks is more of a recent trend, and hence it could be under-reported. Another meaningful comparison could me made when taking our custom S&P without MAGA index as the basis for the β calculation. When that is done the β value comes out to 1.90, which shows that MAGA stocks have a significant impact on the volatility of the S&P500 as a whole.

MAGA Risks = Market Risk?

We clearly see that MAGA stocks do not tend to give momentum to non-MAGA stocks while they boom. However, as we can see the S&P500 without MAGA does have a higher correlation when there is negativity concerning MAGA stocks. This is a really important pattern to observe as MAGA stocks are exposed to strong risks.

Specifically, Amazon and Google use consumer data and information to develop targeted advertising services. The US political climate after the Cambridge Analytica scandal concerning Facebook has been strongly sceptic against data collection, and higher standards of data protection might be pursued by legislators in Washington D.C. This wouldn’t be new as it would most likely closely mirror the recent data protection regulations that have been introduced in Europe. However, such a move can only further limit the advertising revenue growth for Amazon and Google.

MAGA stocks are generating important revenues from Emerging Markets. However, a stronger USD outlook lowers the EM demand for MAGA products. This can bring lower revenues if the strong USD story accelerates.

Apple and Amazon are specifically exposed to risks originating from trade disputes. Apple might see higher costs for the hardware that is mostly being manufactured in China, while increased costs for Asian goods might limit the margins for products that Amazon sells.

The MAGAs are all focusing on the expansion of their cloud systems, and the growth in the cloud segment of these businesses is a promising factor for investors. However, the cloud business could become increasingly unipolar, as mentioned previously is often the case within tech subsegments, hence at least two out of these four stocks can see lower growth expectations from investors.

Overall, when high P/E ratios of MAGA stocks are combined with all these threats we can see strong movements in the share prices leading to lower MAGA strength.

Implications of a MAGA Heavy ETF Market

If we look at the top SEVEN ETFs that have a MAGA exposure greater than 6% there are 703,47 Billion USD involved. The total MAGA share in these 8 ETFs is $111B. A downward trend in MAGA stocks might push investors to sell these ETFs, and as a consequence the originators of these ETFs will have to sell a portion of their holdings, which can even lead to a general market sell-off. This is significantly important for S&P500 stocks other than MAGA as the managements of these companies have little they can do if this kind of sell-off happens. However, there are ways to hedge the MAGA risks of these portfolios. Using put options of MAGA stocks can be the simplest way. But, as MAGA stocks were one of the most profitable trades in the market, such a hedge would put a tight limit on the returns of such portfolios.

Another way to feasibly hedge the MAGA risk might be holding put options for EM currencies to lower the impact of the weak EM demand risk. This might be combined with overweighting one of MAGA stocks, in hoped that this company will establish a clearer dominant position in the cloud business. The ways to hedge MAGA stocks can be infinitely continued, however, investors are also faced with the question of finding growth stocks other than MAGA. This is a hard task considering their historical performance, and their unmatched reputation for being sound investments.