Bear markets are generally not good news for exchanges. Bull markets generate a lot of trading, while bear markets are typically characterized by low volumes as investors wait for the all-clear signal. In CME Group's (CME -0.75%) case, though, the bear market in bonds in 2022 was actually good news -- even though its stock dropped over the course of the year. Why is that?
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CME is a group of exchanges trading futures and options
CME Group is a company of exchanges including the Chicago Mercantile Exchange, the Chicago Board of Trade, the Commodity Exchange, and the New York Mercantile Exchange. Investors can trade stock index futures and options, commodities, and interest rate products.
Interest rate products are CME Group's biggest product, and include Treasury futures and derivatives based on short-term interest rates like Ameribor or the Secured Overnight Financing Rate. Companies use interest rate options to lock in borrowing rates or lending rates. For example, a company that has borrowed money at a floating rate might use interest rate derivatives to limit how much it pays if rates rise.
CME Group was negatively impacted by the Fed's 0% interest rate policy
In the immediate aftermath of the pandemic, the Federal Reserve cut the federal funds rate to a range of 0% to 0.25% and kept it there in order to stimulate the economy. This 0% interest rate policy ended up depressing volumes for interest rate products. While there were probably plenty of investors who were interested in products that would make money if rates rose, there needs to be someone to take the other side of the trade. Nobody is going to bet that interest rates are going to fall when they are already at 0%.
In the past year, the Fed has been raising the Federal Funds rate aggressively in order to combat inflation. This tight monetary policy has translated into a bear market for bonds, especially Treasuries. The increase in rates has brought back the incentive for investors to bet that interest rates might go lower. It has translated into a 28% increase in average daily volumes for interest rate products in the third quarter of 2022. CME Group has seen an increase in equity products despite a bear market in stocks, however this is driven by more investor interest in passive investments and smaller contract sizes.
Investors are beginning to think that interest rates have peaked for this cycle and the Fed will be cutting interest rates next year to fight a recession. If interest rates have indeed peaked, the bear market in bonds could be over. The inverted yield curve suggests that we will be heading into a recession, which means the Fed might begin cutting rates.
That might sound like bad news for CME. But even if the Fed cuts rates marginally next year, the problem presented by 0% interest rates probably won't recur. As investors realize that, CME stock should start to turn around.
CME has little to no competition
CME Group earns money on trades through clearing and transaction fees, which are a per-ticket charge when a trade is made. CME Group also earns money by selling its data to aggregators like Bloomberg or Reuters. Clearing and transaction fees make up 80% of CME Group's revenue. Investors trade with CME because the liquidity is the best, and for that reason CME is almost a monopoly. The barriers to entry are formidable for a new entrant to come in and try to trade these products.
CME has high margins as well, with 56% of revenue dropping to the bottom line. At current levels, CME Group is trading with a relatively high multiple of 20 times expected 2023 earnings per share. The company paid a normal quarterly dividend of $1 per share this year and also paid out a $4.50 special dividend. If you include all of these together, it gave the company a dividend yield of 5%.
The P/E multiple is on the high side compared to the market, but that reflects CME's competitive moat. The dividend yield is also attractive enough to make sense for income investors, although without the special dividend, CME yields about 2.4%. Still, CME is benefiting from rising rates and the growth of equity index futures and options.
