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Is CME Group a Buy?

The general rule for financial investors in 2020 has been to avoid taking credit risk. Banks have been forced to take huge writedowns for expected future credit losses, and real estate investment trusts (REITs) have been dealing with tenants who are struggling to pay their bills. Both sectors have been hit hard as a result.

Financial stocks with limited credit risk have been better places to hide during this period -- take the exchanges, which you'd expect to do well amid higher volatility and increased market activity. But not all of them have rewarded investors this year -- CME Group (NASDAQ: CME) in particular has struggled. Is this a buying opportunity?

Image source: Getty Images.

CME Group owns some venerable names

The CME Group owns and operates the world's largest futures and options exchange through venerable institutions like the Chicago Mercantile Exchange, the Chicago Board of Trade, and the New York Mercantile Exchange. Like most exchange operators, CME Group generates most of its revenue from clearing and transaction fees. These are per-ticket charges paid for by the people who make the trades. The company also generates revenue from selling market data to media like Reuters and Bloomberg, as well as to professional investors.

The exchanges have a huge competitive advantage since the barriers to entry are massive. Investors tend to flock to where the liquidity and volume are highest. While the exchanges will compete with each other in the market for certain financial products, as a general rule it is hard for a competing exchange to replicate what CME has built. As you'd expect, CME's business is highly profitable -- its operating margin was 53.9% in the second quarter.

Volatility and the problem with 0% interest rates

As a general rule, volatility is a good thing for the exchanges, since volatility generally translates into trading activity, which means more fees. While the early part of 2020 was a period of high bond market volatility, that has ended, and now the bond markets are remarkably stable. With the Federal Reserve tightly controlling short-term rates and actively buying Treasuries to anchor long-term rates, volatility in the bond market has collapsed.

This collapse is a problem for CME because one of the company's main products is interest rate derivatives. These products allow users to hedge against interest rate movements, and falling volatility equates to falling demand. The second issue is that interest rates are close to zero now. While we do see negative interest rates in foreign long-term debt markets, short-term rates like the U.S. federal funds rate and LIBOR, the London Interbank Offered Rate, generally can't fall below zero. This matters when an investor is worried about falling rates. There are some assets that fall as interest rates decline, especially assets like mortgage servicing rights. When rates are close to zero, the cost of hedging that risk generally outweighs the exposure. This means that lots of potential volume dries up.

That is exactly what CME Group is dealing with at the moment, and it explains why revenue fell 7.2% in the second quarter. On the second-quarter earnings conference call, management discussed the drop in volatility and their belief that it will be short-lived. The sheer amount of government debt issuance over the past six months will create its own hedging demand, especially as the Fed withdraws its unprecedented intervention in the bond markets.

CME has underperformed its stock exchange peers

Year to date, CME Group has underperformed Intercontinental Exchange and Nasdaq. Stock market volume has been strong and ICE also has exposure to the red-hot mortgage market (in addition to its ownership of the New York Stock Exchange).

CME data by YCharts

Investors who are interested in the exchanges might want to stay with the ones that are riding a bull market with decent volatility. CME Group's low-volatility problems will eventually end, but the stock might be dead money until that happens.

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Brent Nyitray, CFA has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends CME Group and Intercontinental Exchange. The Motley Fool recommends Nasdaq. The Motley Fool has a disclosure policy.


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