Options on U.S. markets are probably too inexpensive: Sebastian

Key Concepts

• Average True Range (ATR): A technical indicator that measures market volatility by calculating the average daily price range over a specified period.
• VIX (CBOE Volatility Index): A measure of the implied volatility of S&P 500 index options, often referred to as the "fear index."
• Option Premium: The price paid by the buyer of an option contract to the seller.
• Covered Call ETFs/Mutual Funds: Investment vehicles that sell call options on underlying assets to generate income.
• Event Risk: The risk of an unexpected event (e.g., economic data release, geopolitical development) causing a significant market move.
• MAG7: Refers to the seven largest technology companies in the S&P 500: Apple, Microsoft, Alphabet (Google), Amazon, Nvidia, Meta (Facebook), and Tesla.
• PCE (Personal Consumption Expenditures) Price Index: A key inflation gauge closely watched by the Federal Reserve.
• Diminishing Returns: A point where the addition of more input (e.g., investment, effort) results in progressively smaller increases in output.
• Chip Glut: A situation where the supply of semiconductor chips exceeds demand.
• Market Cap Weighted Index: An index where the weight of each constituent stock is determined by its market capitalization.
• Equal Weight Investment: An investment strategy where all constituents in an index or portfolio are given equal weighting, regardless of their market capitalization.

Market Volatility and Option Pricing

Mark Sebastian highlights that the S&P 500 is experiencing significant daily swings, with the Average True Range (ATR) reaching approximately 1.2% over the past couple of weeks. He contrasts this with the VIX, which is currently around 16. Sebastian argues that a 1.2% daily move is more indicative of a 19% daily movement, suggesting that options on US markets are currently "too inexpensive." This implies that option premiums are not adequately reflecting the actual volatility observed in the market.

Impact of Option Selling on Market Dynamics

Sebastian points to the rise of "giant covered call ETFs and mutual funds" that systematically sell option premium on a daily, weekly, and monthly basis. This trend, he suggests, has shifted the market dynamic from the historical assumption that "options are always overpriced" to a situation where options on major indices like the S&P 500, Triple Q (Nasdaq 100 ETF), Dow Jones Industrial Average, and Russell 2000 are "underpricing event risk."

Example of Underpriced Event Risk

A classic example cited is the period leading up to a weekend where options were pricing in only a $97 move on the S&P 500 between Friday and Friday. This was despite a confluence of significant economic events, including a potential China deal, uncertainty around a government shutdown, earnings reports from five of the MAG7 companies, and the Federal Reserve's PCE data release. The market's pricing of a mere 1.5% move was significantly contradicted by the S&P 500 rallying $83 on the following Monday. Sebastian reiterates that even with substantial economic data still to come, the market was pricing in only a 75-point move between the current day and Friday.

Covered Call ETFs: Pros and Cons

Sebastian acknowledges the increased popularity of covered call ETFs, which aim to generate yield for investors through option premium sales. However, he expresses skepticism, noting that these funds can underperform plain vanilla indexes.

Strategic Use vs. Primary Investment

While covered call funds might have a "place in a portfolio" for producing some income, particularly for older individuals, Sebastian strongly advises against them being a "primary form of investment." He explains that these funds tend to capture most of the downside moves while missing out on significant upside when the market rallies, as seen in the recent Monday surge.

Market Overvaluation and Chip Sector Concerns

Sebastian expresses concern about potential overvaluation in the broader market. He specifically focuses on the chip space, noting significant developments:

• Qualcomm's new competitor for Nvidia's GPUs.
• AMD's deal with OpenAI.
• Changes occurring at Intel.

Potential for a Chip Glut

Drawing a parallel to commodity trading, where "the solution to high prices is high prices," Sebastian believes that the current cycle for AI chips, while longer-term, could eventually lead to a "glut of AI chips." He anticipates this due to increasing competition, the potential for diminishing returns as chip technology advances, and a possible slowdown in AI buildout. He states that this is "100% on the cards" and something Nvidia investors should be considering.

Diversification Concerns in Major Indices

Sebastian raises a critical point about the lack of diversification for many investors who hold popular ETFs like the QQQ (Nasdaq 100 ETF) and SPY (S&P 500 ETF).

Concentration in Top Holdings

He highlights that the top eight stocks in the Triple Q constitute over 67% of its value, and these same companies make up about 34-35% of the S&P 500. This means investors holding both SPY and QQQ are "kind of overallocated to those top eight names that have kind of taken over the market."

Dow Jones as a More Diversified Option

Ironically, Sebastian suggests that the Dow Jones Industrial Average, with its 30 stocks, appears to be "more diversified than the S&P 500 and certainly the Triple Q."

Recommendation for Equal Weighting

His concern is that a "sneeze in these kind of top eight names" could significantly impact the market. Consequently, he is "migrating some of my investments out of the S&P 500, which is cap weighted, and looking for equal weight investment opportunities."

Conclusion

Mark Sebastian's analysis points to a market where options are currently underpriced relative to observed volatility, largely due to the systematic selling of premium by covered call ETFs. This trend, while offering some yield, comes at the cost of missing upside and capturing downside. He also expresses concerns about potential overvaluation, particularly in the chip sector, where increased competition and technological advancements could lead to a future chip glut. A significant takeaway is the lack of true diversification in popular market-cap-weighted ETFs, leading Sebastian to advocate for equal-weight investment strategies.