JEPQ: Survived Volmageddon 2.0, But Concerns About Valuations Remain

seekingalpha2024-08-13

JEPQ ETF survived recent volatility event with only a small drawdown, proving its resilience.Investors should be cautious of high-valuation growth stocks like NVDA and Microsoft held in JEPQ ETF.There...

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Hinterhaus ProductionsIn April, I penned an article on the JPMorgan Nasdaq Equity Premium Income ETF (NASDAQ:JEPQ) titled \"Volmageddon 2.0 Fears Overblown\". Given the spike in volatility in the previous week, I thought it was an apt time to revisit my conclusions from the article and discuss how investors should view the recent drawdown in the JEPQ ETF, which bottomed at ~10% during last week's volatility event (Figure 1).   Figure 1 - JEPQ declined nearly 10% from its recent peak (Seeking Alpha)In my opinion, rather than worry about 'Volmageddon 2.0' risks, investors need to be comfortable with the high-valuation growth stocks held in the JEPQ ETF. Judging from recent news articles, it appears business leaders and investors are growing more wary of the elevated valuations in AI-related companies like NVIDIA (NVDA) and Microsoft (MSFT). In a worst-case scenario, a bursting of the AI-bubble could set the JEPQ ETF back for years, similar to what happened to Nasdaq-100 stocks in the early 2000s. I remain cautious on the JEPQ ETF and rate it a hold. Brief Fund Overview First, for those not familiar with the JPMorgan Nasdaq Equity Premium Income ETF, the JEPQ ETF is a relatively straightforward buy-write ETF focused on stocks within the Nasdaq 100 Index (Figure 2).   Figure 2 - JEPQ investment process (am.jpmorgan.com) JEPQ's strategy aims to provide ~9-11% in distribution yield, plus equity participation in its stock portfolio (Figure 3).   Figure 3 - Illustrative returns of the JEPQ ETF (am.jpmorgan.com) JEPQ has been very popular with investors, hoovering up over $15 billion in assets while charging a modest 0.35% expense ratio (Figure 4).   Figure 4 - JEPQ overview (JEPQ factsheet)JEPQ Survived Trial By Fire In the past few quarters, many market pundits have been fear-mongering and drawing analogies between the rise of derivative income funds like the JEPQ ETF and the infamous 'Volmageddon' blow-up of 2018 (Figure 5).   Figure 5 - Option income assets have boomed (Bloomberg) As I explained in my previous article, the JEPQ ETF was unlikely to 'blow-up' like the short-volatility funds in 2018, since JEPQ's buy-write strategy owns a basket of stocks and shorts out-of-the-money (\"OTM\") call options instead of VIX futures. In order for the JEPQ ETF to be 'wiped out', the stocks within the JEPQ ETF would have to all go to zero overnight, a near impossibility. JEPQ's performance during last week's volatility event, where the spot VIX index surged to 65 in Monday's pre-market trading, proved my point. While the JEPQ ETF lost 2.78% on August 5th, it was nowhere near the 'Volmageddon 2.0' level losses suffered by short volatility ETFs like the -1x Short VIX Futures ETF (SVIX), which lost 38.7% (Figure 6).   Figure 6 - JEPQ lost 2.78% on August 5th, 2024 (Yahoo Finance)But the Fundamental Issues Remain Although JEPQ survived 'Volmageddon 2.0' with only a small drawdown, that does not necessarily mean it is a strong buy candidate. In my prior article, I also noted two fundamental shortcomings of the JEPQ ETF that remain. First, during strong equity rallies, the JEPQ ETF will underperform its index because JEPQ has traded away upside for premium income. For example, from October 31, 2023 to July 10, 2024 (the most recent multi-month rally for the markets), the JEPQ ETF only returned 30.6% compared to 44.1% return for the Invesco QQQ ETF (QQQ), or an upside capture of 69% (Figure 7).   Figure 7 - JEPQ underperforms in bull markets (Seeking Alpha)More importantly, I believe the JEPQ ETF is at serious risk of a significant drawdown, as the securities held within its equity portfolio trade at elevated valuations, with P/E of 27.4x and P/B of 6.8x (Figure 8).   Figure 8 - JEPQ portfolio valuations are elevated (Morningstar)This is far in excess of the equity market, as represented by the S&P 500 Index, which itself is trading at a multi-year high Fwd P/E of 21.4x, the highest since the dot-com bubble in 2000 and the meme-bubble in 2021 (Figure 9).   Figure 9 - S&P 500 Fwd P/E (yardeni.com) For investors to consider the JEPQ ETF to be a buy at current valuation levels, they need to believe that JEPQ's core holdings like Apple (AAPL) and Microsoft (MSFT) will continue to deliver strong equity returns despite trading at elevated valuation multiples (Figure 10).   Figure 10 - JEPQ top 10 holdings are dominated by megacap tech companies (am.jpmorgan.com)According to data from Yardeni Research, the Megacap-8 stocks (Alphabet (GOOG), Amazon (AMZN), Apple, Meta (META), Microsoft, Netflix (NFLX), NVIDIA, and Tesla (TSLA)) are collectively trading at 27.6x Fwd P/E (Figure 11). While not as extended as in early 2021 when they were trading at over 35x Fwd P/E, the group is not 'cheap' by any stretch of the imagination (Figure 11).   Figure 11 - Megacap-8 valuations are elevated (yardeni.com)Is The AI-Bubble Deflating? In particular, there appear to be growing concerns about the profitability of artificial intelligence (\"AI\") related companies, the investment theme that has been powering the Megacap-8 in recent quarters. Compared to the tens of billions of dollars being spent on data centers and semiconductor chips to train large language models (\"LLMs\"), the chatbot and term paper writing use cases appear trivial. A pharmaceutical company recently decided to terminate its trial of Microsoft's Copilot, as the company's CIO could not justify the added $30 per month cost of the AI tool. According to data from Similarweb, OpenAI's ChatGPT's popularity appears to be waning dramatically, as unique visitors per month have plummeted from 1.8 billion in April 2024 to only 260 million in June (Figure 12).   Figure 12 - ChatGPT users have plummeted (Similarweb via explodingtopics.com)AI competitors like OpenAI, Gemini (Google), Llama (META), and Claude (Anthropic) all appear to be burning money to train LLM models that are roughly equivalent in terms of quality and speed, without any moats or barriers to entry except perhaps money (Figure 13).   Figure 13 - Leading LLM models are roughly equivalent (artificialanalysis.ai)All-in-all, the current AI investment wave appears to be a replay of the 2000 dot-com bubble, where the hype of the Internet drove stocks to valuation levels far in excess of what could be justified by their subsequent earnings and profitability. For investors who bought the Nasdaq-100 Index near the dot-com bubble peak in early 2000, it took almost 2 decades before they eventually broke even once the bubble burst (Figure 14).   Figure 14 - It took 16 years for Nasdaq 100 Index to break even after dot-come bubble burst (Author created using stockcharts.com)I worry that current Nasdaq-100 investors, including JEPQ ETF investors, may be disappointed in the coming years as the AI bubble bursts. Conclusion The JEPQ ETF is a growth-focused ETF using a time-tested buy-write strategy to provide enhanced income from writing call options on the Nasdaq 100 Index. As I have explained in prior articles, the fears of a 'Volmageddon 2.0' event on derivative income funds like JEPQ were overblown, as JEPQ holds a basket of stocks that will not go to zero overnight. This point was proved last week, when the JEPQ only declined by 2.78% on August 5th despite the VIX index surging to 65 in pre-market trading.  Instead of overnight crash risk, investors need to consider the fundamental risks of owning high-valuation growth companies like NVDA and Microsoft. In my opinion, there is a growing realization from business leaders and investors that the AI investment theme may not be sustainable, as the current AI use cases do not justify the cost of developing and adopting these LLM models. I remain cautious on the JEPQ ETF and rate it a hold.","kind":"highlight","is_publish_news":true,"is_publish_highlight":false,"is_publish_live":false,"is_publish_wemedia":null,"editions":null,"column":"","sentiment":"-1","news_tag":"","news_rank":0,"symbols":[],"gpt_button":0},"commentList":[],"isCommentEnd":true,"newsSizeData":{"likeSize":0,"commentSize":0,"repostSize":0,"favoriteSize":0,"likeStatus":false,"favoriteStatus":false},"APP":{"userAgent":"Mozilla/5.0 AppleWebKit/537.36 (KHTML, like Gecko; compatible; ClaudeBot/1.0; +claudebot@anthropic.com)","isDev":false,"isTTM":true,"deviceId":"web-server-community-laohu8-v3","version":"4.30.2","shortVersion":"4.30.2","platform":"web","vendor":"web","appName":"ttm","isIOS":false,"isAndroid":false,"isTiger":false,"isTHS":false,"isWeiXin":false,"isWeiXinMini":false,"isWeiBo":false,"isQQ":false,"isBaiduSwan":false,"isBaiduBox":false,"isDingTalk":false,"isToutiao":false,"isOnePlus":false,"isHuaWei":false,"isXiaomi":false,"isXiaomiWebView":false,"isOppo":false,"isVivo":false,"isSamsung":false,"isMobile":false},"href":"/m/news/2459920971"}