How S&P500 inclusion could burst the Tesla bubble!
Tesla has been the poster child of panic buying. If anyone doesn't know what FOMO looks like and what it can do with one's investment approach, just look at Tesla. There are many Tesla believers who have made a lot of money in Tesla, there are many speculators gambling in Tesla stock via options, and then there is the whole TSLAQ community (anti-Tesla / Tesla shorting community).
In August 2018, Elon Musk announced that he wanted to take the company private at $420. At that time, the Tesla stock was trading around ~$70 (in today's post-split price) or ~$350 (pre-split price). After that debacle, the stock declined to $35 in May 2019 (in today's post-split price). However, since then the stock has gone on a meteoric run, growing 20x in 1.5 years. This is kind of surreal when you think about Tesla's size. Right now, Tesla has a market cap of $677B with an unrealistic valuation at P/E: 1376 or Fwd P/E at183. Compare this to the P/E and CAPE for S&P500. These stand at 37.4% and 33.8% respectively (shown below). Tesla's P/E ratio is ~37x the average P/E of the 500 biggest companies with Tesla being among the top 10.
There is just no way to justify these sky-high valuations. But wait, it gets even more interesting.
As of November 19, 2020 (link), Tesla's market cap was higher than the combined market cap of the following auto-makers.
General Motors Company (NYSE: GM)
Ford Motor Company (NYSE: F)
Fiat Chrysler Automobiles NV (NYSE: FCAU)
BMW (OTC: BMWYY)
Honda Motor Co Ltd (NYSE: HMC)
Hyundai Motor Company (OTC: HYMTF)
Nissan Motor Co Ltd (OTC: NSANY)
Mazda Motor Corp (OTC: MZDAY)
Aston Martin (OTC: ARGGY)
Subaru (OTC: FUJHY)
Volkswagen (OTC: VWAGY)
Daimler (OTC: DDAIF)
And with the recent rise, it is now above or almost equal to a combined market cap of all of the above auto-makers and Toyota Motors (which has a market cap of $249B). In other words, the investors expect everyone to buy a Tesla and no other car, the number of cars in the world to double, or Tesla is defining a totally new industry and is much beyond cars e.g. electric battery / electrification industry.
While one can make an argument that Tesla is about more than just cars, it is hard to believe that the rise in Tesla's stock price is just driven by that belief. Typically, in order to trigger and sustain a monster rally, one needs to buy a lot of shares. This kind of buying power normally comes from institutions. Hence, till institutions are bought into a story, it is hard to move a stock such drastically for so long. But it is difficult to convince the institutions without showing results. For them, just pure genius isn't enough because they want to ensure that they are investing in a fiduciary way. Since Tesla wasn't consistently profitable till just 2 quarters ago and the management wasn't very mature, it is hard to believe that institutions fueled the rally.
Then the question becomes, is there another way to maneuver a stock without buying the actual shares which would need smaller capital but can have a significant impact on the underlying price. This is where it gets interesting!
Recently in August, the finance media found out about the options whales who were buying a significant amount of call options and influencing the underlying stocks. While this strategy came into the limelight in August, this has been practiced by many Reddit readers since mid-2019. So what is it and what does it do?
By buying a single contract of TSLA call option (100 shares) a person gets the right to buy 100 shares of stock by a certain date at a given strike price. These weekly options are typically cheap because they are very close to expiry. However, in order to manage risk, the option seller also buys the underlying stock, so that he/she doesn't have to buy the stock at a higher price in case the stock goes up. This creates artificial demand for the underlying stock without putting down a lot of money. If many people do this, the stock starts to move up because of demand from the options seller (market maker). As it moves up, more stocks are bought by the market makers to hedge their position. Now add into the mix Elon's tweets, buying pressure on the existing shorts, and constant news flow, and this creates a self-feeding cycle where more people keep joining the band.
This speculative behavior by individuals and some institutions has been a big driver of the rise in the stock price. This perpetual motion machine of hype and call option flows is something that is being discussed by the financial experts for a few months but hasn't led to any substantial decline. So how will Tesla's addition to S&P500 index impact the stock price (negatively in due course)?
When a stock joins the S&P 500, it becomes part of a massive volatility complex, which is a terrifying web of arbitrage and pseudo-arbitrage relationships. Tesla will join the index as a top-ten component of a cap-weighted index, which means it is very big. Such a big size will allow all manner of dispersion, relative value, and market-making traders to begin relying on Tesla's newfound correlation to the index. For example, causing arbitrageurs to buy SPX options and sell Tesla options to "close the spread."
As discussed earlier, one of the big drivers of the Tesla stock was call option activity. And the call options are impacted by the implied volatility (option prices) and delta (stock exposure). Since June, data shows that most of Tesla's gains can be attributed to the rise in the implied volatility.
However, when Tesla joins the SP500 index, these historic call option flows and the hype machine behind them will hit the big red fire truck that is the S&P500. As Tesla is tied to the SP500, it will face downward pressure from so many other aspects like futures, systematic trading algorithms, investment advisors, and others etc.
Implied volatility will be unable to rise as fast as it did in the past. As a result, prices will not increase, and call options will bleed value. As options lose value, speculators will stop speculating, and new flows will be absorbed by real traders. With the call option hype trade hampered, the stock will have no possibility of further returns through options. Future returns will be driven by actual earnings. And if there is a stock with such rich valuations as compared to the other cohort of SP500 companies, there is a good chance that this stock will be shorted as part of hedge fund strategies.
Little or no support for higher prices from options activity
The stock performance will be dependent on the actual earnings, which has been sketchy and the valuations are too stretched
Potential additional supply from the index, hedge-fund, and arbitrage short-sellers
Therefore, Tesla will have a tough time making the same type of gains it generated over the past year and a half.
"An appropriately ironic fate for Tesla -- a victim of its own success." (Squeeze Metrics)
A similar thing happened when Bitcoin futures were launched. Bitcoin futures were launched on Dec 10 and Dec 17, and the Bitcoin topped on Dec 17th, 2020. There was an additional supply that came into the market. SP500 addition of Tesla will bring an additional supply.
The next few months will be very interesting. From a structural perspective, the stock can go down below $300 and even then remain in an uptrend. So to conclude, no matter how one looks at the Tesla story, it is a dangerous time to be a Tesla investor. Tesla has taken advantage of the stock price and raised a lot of cash to fund operations and expansion. Therefore, it now has a good runway and can continue to do good. However, returns like the past year will not be likely and even a 50% correction will not mean the end of Tesla, it will be a breather that allows Tesla to settle down. However, if the economic downturn continues or exacerbates, this rich valuation could be the biggest problem for Tesla. Historically, such high valuations have not resulted in promising long-term returns for other companies in similar situations (case in point AOL in the 1990s).
Twitter - Squeeze Metrics