Part 3

Understanding Beta With A Real World Example

Our Head of Research, Tom Lee, made one of the great “blood in the streets” market calls of the 21st century when he told investors to pile into the worst affected stocks by COVID-19 or those at the “Epicenter” of the crisis. We did another guide on the rise of ETFs. One such ETF actually gives you direct exposure to the 100 stocks in the S&P 500 with the highest beta, the $SPHB. The nature of beta itself and which stocks exhibit the highest beta will change when the catalysts drive the market change. For example, when the market was processing the extraordinary economic impact of COVID-19.

About 7% of the economy were the heavily affected “social distancing casualties. When the catalyst of COVID-19 came to be a primary driver of markets, these stocks would routinely be up or down far more than the market since their fortunes were so heavily tied to COVID-19 cases and related restrictions. Because of this, these stocks had the highest beta for much of the period, dominated by COVID. We, therefore, suggested SPHB as a good way to get exposure to the Epicenter trade.

Understanding Beta With A Real World Example
Source: Seeking Alpha

As you can see, in early 2021, the SPHB outperformed the broader index. When COVID was driving markets, the index, which is rebalanced quarterly, was primarily comprised of hard-hit travel names and cruise lines. There were also a lot of energy and financial components. However, as the Fed cycle transitioned to tightening around the End of 2021, interest rates rose. When interest rates rise, so does the discount rate for stocks, which means companies with more of their net present value comprised of future earnings get hit particularly hard.

So, as the driver of a hawkish Fed and rising interest rates became more prevalent as COVID simultaneously retreated, the highest beta stocks in the market changed from the COVID-19 social distancing casualties to technology companies with high P/E ratios. These stocks experienced more significant losses than the overall market and stocks with lower P/E ratios and thus led the way down. So as the catalysts in the market change and as specific drivers for particular groups of stocks ebb and flow, the highest beta companies comprising the SPHB index will change dramatically.

Understanding Beta With A Real World Example

Seeing what is in the SPHB ETF is one way of getting the market’s temperature. What is in the index will illuminate what key catalysts the market is attempting to discount. As the market digests new information, it often overshoots, undershoots, and then overshoots again. While catalysts may be unique to each time, this perennial pattern has been a feature of markets since their inception. You can see below that even though there was almost no technology in the SPHB in early 2021, by May 2022, the holdings of SPHB are dominated by Technology names that have suffered from multiple compression. The measurement of Beta certainly hasn’t changed, but the main catalysts driving prices certainly did.

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Investor Psychology 200
3 Lessons
~10 mins in total
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