Jim Iuorio, for CME Group
At a Glance:
- The Magnificent 7 tech companies are having a significant influence on the Nasdaq-100 and S&P 500
- A lower-than-expected CPI print and the market’s anticipation of the Fed’s easing cycle contributed to the sector rotation in mid-July
The sector rotation trade that began on July 11 between the Nasdaq-100 and the Russell 2000 was of historic proportions. In the five-day period that followed, the Russell 2000 rallied 11.5% while the Nasdaq-100 lost almost 5%. For perspective, this move marked the largest five-day divergence in the history of these indexes. The narrative that drove this move had several important layers.
First, on July 11, we saw a lower-than-expected CPI print that convinced the market that the Fed was going to begin its easing cycle by the September meeting. Lower short-term rates disproportionately affect the small caps in the Russell 2000 compared to the broader market because the companies within this index are three times more likely to use floating-rate debt than their larger counterparts. In normal circumstances, a positive fundamental change for one index would have typically lifted all indexes. But we weren’t in normal circumstances.
For the past two years, a common trade was to short the Russell 2000 and buy the Nasdaq-100 or the “Mag 7" tech companies within the Nasdaq-100. This trend led to massive long positions in technology in general, but more specifically, in companies like NVIDIA, Apple, Microsoft, Amazon, Tesla, Meta and Alphabet (Google’s parent company). At the market’s peak, these seven companies accounted for 40% of the Nasdaq-100’s total market cap. Additionally, the information technology sector accounted for over 30% of the weighting in the S&P 500, led by those same seven names. The other commonality between these companies is that they all are connected to artificial intelligence, which has become a popular investing theme recently. The fervor became so pronounced that it pushed analysts to point out some parallels to the tech run-up in the late 1990s, as the internet became ubiquitous.
Rising Influence of Tech Stocks
Since the beginning of 2023, the S&P 500 had rallied over 40% at its highs on July 11. However, the equal-weighted S&P 500 was only up 20% in the same period. This suggests that over half of the total performance over the 18-month period was almost solely due to the Mag 7 stocks, led by NVIDIA.
This concentration of capital in a handful of tech giants created a precarious situation, particularly when viewed as a pairs trade against shorts in the small caps. As investors began to reassess their positions in light of the new economic outlook, the overweight positions in these tech companies became vulnerable to a significant pullback. As the Russell 2000 rallied on the good news, squeezing out short positions, tech began to fall with the long liquidations.
Initially, the two-way volatility in the Russell 2000 and the Nasdaq-100 appeared contained and did not spread to the broader S&P 500, which only lost around 1% from July 11 to July 18. At that point, the move in tech began accelerating as longs rushed to the exits, pushing the S&P 500 to a low of down 10% on August 5th. NVIDIA, the bellwether of the up move, lost 34% in the same period.
As market participants looked to manage risk around these changing conditions, more traders turned to the futures and options markets, with CME Group reporting a record July Equity Index average daily volume (ADV) of 7.4 million contracts. ADV in CME Micro E-mini Russell 2000 futures were up 61% in July versus June with more participants seeking small cap exposure.
The Nasdaq-100 suite of products have also played an important part in this growth with E-mini Nasdaq-100 options experiencing a record July volume. Micro E-mini Nasdaq-100 futures continue to see interest, reaching a single day volume record of 3.4 million contracts on August 5 as changes in the tech sector remain in focus.
Continued AI Growth?
There is little doubt that the fundamental story of artificial intelligence is of significant importance. Of course, that thesis does not mean “at any price.” Markets can become over exuberant when pricing in disruptive technology, pushing prices to potentially unsustainable levels.
If a trader believes that the AI theme will continue but that the brightest stars within the sector remain stretched, there are ways to express that thesis with a pairs trade, which is a strategy that looks at two markets with a typically high correlation. One way would be to short names like NVIDIA against a long position in Nasdaq-100 futures. However, as previously mentioned, the Mag 7 currently comprise about 40% of the Nasdaq-100 with NVIDIA being near the top, so much of that trade would be long and short positions in essentially the same assets.
Perhaps a better way to effect this hypothetical scenario would be to use CME E-mini PHLX Semiconductor Sector futures (SOX). This index is based on the Philadelphia Semiconductor Index and has 30 underlying components. Many names associated with AI chips are included in the index, like NVIDIA, AMD and Micron. A key difference is that the semiconductor index periodically adjusts its components to ensure it includes only the top 30 largest companies by market capitalization. Although not perfect, this could reflect a more accurate representation of the trade thesis.