Stock market indexes are not the economy, and vice versa. My colleagues covered the topic last summer, asserting that the key distinctions are primarily a matter of size and measurement periods. However, most investors view the performance of benchmarks like the Nasdaq-100 Index (NDX) as a forward-looking reflection of economic activity.
The team at JP Morgan Wealth Management echoes these sentiments, pointing out that “the stock market almost always bottoms well before a recession is over, and sometimes before we even know that we’re in a recession,” adding, “equity markets are publicly traded 252 days a year. They are the best forward-looking mechanism for economic growth and earnings. GDP, by definition, is a backward-looking growth number.”
So, what (if anything) is the NDX telling us about the economic forecast?
At a cursory glance, the NDX makes it look like the worst is behind us. An optimist would point out that the NDX has rallied nearly 23% off the lows. A pessimist might argue that the index is essentially measuring where it was in early 2021. They would both be correct.
However, in early 2021, the cost of money was substantially lower than it is today. The Fed Funds rate in January 2021 was nine basis points (or 0.09%); it’s currently 508 basis points (or 5.08%). Put another way, average 30-year mortgage rates have moved from 2.65% to ~6.50%. If we tether interest rates back to GDP, keep in mind that housing constitutes about 18% of the total gross domestic product in the United States.
Degrees of Uncertainty
Another Wall Street adage argues that “bad certainty is better than uncertainty.” At present, the NDX levels suggest that the worst-case scenarios have become less likely. Corporate profit margins slowed considerably in 2022 but remain historically strong. Fixed income markets hint that interest rates will peak following the May FOMC statement, and the cost of capital may decline by year-end.
Nevertheless, there’s always a degree of uncertainty in markets, as in life. That reality is in part reflected in growing index option volumes. Average monthly NDX volumes for the calendar year 2022 were just shy of 500k, but through April of this year, that average number is just below 600k.
From my vantage point, investors of all types have a better general understanding of options. Individuals and institutions continue to gravitate toward index options such as the Nasdaq-100 Index Options (NDX), Nasdaq-100 Reduced Value Index Options (NQX) and Nasdaq-100 Micro Index Options (XND), because they allow users to craft defined risk exposure based on their sentiment (depending on strategy) and/or manage their downside risk for the life of the options.
A product that can reduce or eliminate uncertainty is inherently powerful. Index options allow market participants to answer historically ambiguous questions. For example, what if the macro picture deteriorates and the NDX retests lows (drops ~18.5%)?
An investor that owns an NDX Index ETF(or another NDX proxy) with an option hedge could answer that question more precisely than someone without an index option hedge.
Food for thought. Learn more here.
Originally Posted May 30, 2023 – What the Nasdaq-100 Can Tell Us About the Economy
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