The year 2020 has been a mixed bag for the exchanges. The stock market exchanges of NASDAQ (NASDAQ: NDAQ) and Intercontinental Exchange have outperformed, while the derivatives exchanges like CME Group (NASDAQ: CME) and CBOE Global Markets have struggled. Has CME Group fallen enough relative to NASDAQ that it would be a buy?
Cash equities versus derivatives
CME Group focuses primarily on trading derivatives, mainly futures and options. It began as the Chicago Mercantile Exchange, bought the Chicago Board of Trade, and now owns the Commodity Exchange and the New York Mercantile Exchange. The group’s biggest contracts are interest rate derivatives and energy. NASDAQ focuses primarily on cash equity trading and options. The company earns fees from per-ticket charges and clearing fees on trades, and also from selling its data. NASDAQ also sells proprietary software and performs outsourced corporate services like investor relations and corporate governance consulting.
NASDAQ has seen a big uptick in trading volumes
This has been a good year for NASDAQ. Volumes have risen smartly on a year-over-year basis, with third-quarter options average daily volume up 58%. Options average daily volume was up 6% compared to the second quarter despite a drop in market volatility. Cash equity trading average daily volumes rose 44% on a year-over-year basis, although they dropped 20% sequentially. NASDAQ increased its market share of cash equity trading to 51.4% from 49.8% in the second quarter and 49.4% a year ago. We have seen a robust initial public offering (IPO) market this year, which has helped increase volumes as well.
CME Group is at the mercy of the Fed
While NASDAQ has benefited from the turmoil in the markets, CME Group has suffered from it. Volatility drives volumes, and CME has seen the collapsing volatility in the bond market depress revenues. CME Group’s primary product is interest rate derivatives. These include short-term futures and options like LIBOR or Eurodollars, as well as longer-term Treasury futures and options. When the Federal Reserve cut the Fed Funds rate to a range of 0% to 0.25%, the need for many derivatives users to hedge against a further drop in rates vanished. Short-term rates can’t go negative, so why hedge against it?
At the same time, the Fed is buying up longer-term Treasury bonds in an effort to drive down interest rates in order to support the economy. While long-term rates can go negative (the German 10-year trades at -0.63%), many investors are loath to pay the money to hedge such an unlikely risk. The Fed’s buying has sucked the volatility out of the market, and fewer investors are trading Treasury futures and options. Average daily volumes for interest rate products fell 51% compared to a year ago and 23% compared to the second quarter.
Year to date, the two companies have been going in opposite directions. NASDAQ is up 24%, while CME is down 25%.
Markets versus engineers
NASDAQ trades at 22 times expected 2021 earnings per share and has a dividend yield of 1.5%. CME Group has the same price-to-earnings ratio of 22 and has a slightly higher dividend yield of 2.3%. Valuation is a push. For NASDAQ, its future will depend on the U.S. stock market volatility, which might rise, fall, or stay the same. It will be driven by market fundamentals. Now think about CME. The bond market is not being driven by market fundamentals. It is driven by financial engineering — in other words, the Fed.
On Nov. 5, the Federal Open Market Committee said it would “increase its holdings of Treasury securities and agency mortgage-backed securities at least at the current pace to sustain smooth market functioning and help foster accommodative financial conditions, thereby supporting the flow of credit to households and businesses.” Does that sound like the Fed has any interest in seeing volatility in the bond market? The Fed also sees 0% short-term rates over the next several years. This means interest rate products will continue to see lousy volumes, and CME will continue to struggle. CME is a great franchise, but the cards are stacked against it. NASDAQ is the better buy.
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