Tesla: A Ticking Time Bomb?
A brief overview of how Tesla has avoided such drawdowns experienced in the other Magnificent 7 stocks
Magna cum laude graduate of Harvard turned CNBC commentator, Jim Cramer, is very well-known at this point for his consistency in producing directionally incorrect investment recommendations. So much so, that there is now an entire twitter page (@CramerTracker) with 32,000+ followers dedicated to “tracking the stock recommendations of Jim Cramer so you can do the opposite.” During February of last year, ole Jim Cramer, took his screen time on Mad Money to lay out his “Magnificent Seven” stock portfolio of must own names.
Six of the “Magnificent 7” names have plummeted at least -50% since that February of 2021. The last man standing: Tesla, retail investors’ favorite EV company with a market cap just north of $1 trillion. Nasdaq Markets published an article yesterday titled, “Netflix’s Implosion Is a Warning for Tesla,” and I tend to agree but it just begins to scratch the surface of which market dynamics could pressure Tesla’s share price lower. When Tesla follows the path of the other six is not what this article seeks to address. Here, we look to address at a high level how Tesla has managed to delay its inevitable fate and how it could look like the other six stocks in Cramer’s “Magnificent 7” portfolio. What follows might be ugly.
Figure 1: Performance of the “Magnificent 7” Basket
Let’s Start with the Fundamentals
For those willing to hold Tesla shares outright, they earned almost a 20% return if they held their position from February 2021 to today. In Q1 2022, Tesla shocked the street after reporting record profits and revenue growth. The EV maker produced net income of $3.8 billion and revenue growth of 68% year-over-year.
Using bottom-up and classic valuation methodology accounting for revenue, earnings, operating income, and all those fun numbers we can reach an implied value for Tesla’s share price. With Tesla’s record performance this Q1 and previous financial highlights paired with Bloomberg’s assumptions and a basic DCF, we arrive at a share price range at least 58% to 62% below its current market price. With the street’s forecasts and an EBITDA exit multiple of 30.0x, the share price still only produces an implied value of $532.85…
If you like Tesla at $1,005.05, you will love it at $532.85.
Figure 2: 5-Year DCF Valuation Summary Range
So how did Tesla attain such exceptional financial results? The automaker sold 1398 more cars in Q1 2022 than Q4 2021, a 0.45% increase in sales! In 2021, Tesla sold 936,222 cars and now has the largest market cap of any automaker; looking at the major car producers, Volkwagen and Toyota produced 8,881,957 and 7,646,105, respectively. Together, their combined market cap is only one-third of Tesla’s.
Figure 3: Tesla Dwarfs Other Automakers Market Cap, But Not Sales
With a minimal market share in the automotive industry and a trillion-dollar market cap, is it the 0.45% sales growth that boosted Tesla to such valuations? Not exactly. Rather, a combination of factors has allowed Tesla to become the big name that it has amongst investors and traders of all levels. The first factor: markets are materially different following the pandemic. This is widely known. The effects of the meme stock phase linger within the volatility structure of markets.
The Tail Wags the Dog Now
Figure 4: Returns After March 2020
Tesla has returned 1501% in the past 5 years but before 2020, it had only generated 33% of value in total return. In this post-pandemic market structure, the moves – up or down – are intensified by the gamma exposure dynamic (also known as dealer-gamma hedging).
“Dealer-gamma hedging” has broadly taken the helm during some of these major U.S. equity moves. Dealer-gamma hedging is essentially market-makers buying or selling underlying securities when they open a position for someone to buy or sell an option. They are not looking for directionality, they simply hedge whichever way they need to based on what type of market they made. A market maker that writes a call option then must hedge by purchasing shares of the underlying stock.
Figure 5: Tesla Call Option Volume Driving Underlying
You can imagine what happens when call option volume reaches elevated levels – dealers dramatically add to their underlying equity position to manage risk. Bloomberg wrote about this back in October of 2021 when Tesla shares spiked 7% in a trading day. Total call volume surged to September 2020 levels – an isolated volatility event unto itself.
Despite being in a market environment driven by this gamma hedging dynamic, volatility is rather suppressed right now relative to the start of the year, although climbing. Exogenous factors such as Russia, and now the ongoing lockdowns in China should add pressure in addition to the tightening path and a growing recession narrative.
Figure 6: Tesla Call Skew
Figure 6 above looks to assess how sensitive Tesla is to large price swings. In orange we have Tesla’s share price. In blue is the implied 1st month call skew (25-call delta - the 50-call delta) / the 50-call delta), which demonstrates how Tesla’s share price might move in the upcoming trading days - not where, but how. Directionality cannot be derived from this, but a higher implied call skew would mean realized volatility in Tesla’s equity could be on the horizon. But for now, skew looks muted.
So, where are flows going? Michael Green, Chief Strategist at Simplify Asset Management, expressed concerns in a brief Twitter thread posted this weekend. Green notes inversion and its predictive nature of recessions, something sentiment looks to be accounting for. Excluding the major index funds (SPY, QQQ, IWM), fund flows are not supportive of rebalancing for a move higher in equities. Green also notes last week’s negative dealer gamma, meaning dealers sell the dips and buy the rips – not good for directionality.
Here is where it gets nerve-racking. In some extensive research done by Squeezemetrics, negative gamma exposure or exposure below zero results in an exponential increase in volatility.
Figure 7: Negative Gamma Exposure Could Be Trouble (Source: Squeezemetrics)
As gamma exposure gets more negative, we can see that the next day’s returns can look as ugly as nearly -10%. A drawdown of this size would mean the S&P 500 Index could lose $4 trillion of market cap in a single session. Now, this is not to say it will happen but there is the opportunity for it. As mentioned, it seems more variables need to start getting priced in for a big move to occur.
The Potential Troubles from Here
As of now, Tesla looks to be surviving a pretty tough period for the Nasdaq and Cramer’s “Magnificent 7,” so what is there to challenge Tesla’s upward bias in price – the epitome of “stocks only go up.” Well, there are several that we see: 1) it’s weight in Cathie Wood’s ARKK Fund, 2) exogenous shocks to the broader market due to Tesla’s leveraged-like nature, 3) its entanglement with the crypto market, and 4) the ongoing tightening of financial conditions.
1. Cathie Wood’s ARKK Innovation Fund is getting crushed year-to-date, down -45%. During Thursday’s session last week, every holding traded in the red except for Tesla. On a grander scale, Ark Invest nearly put itself in a position of dealing with liquidity issues around this time last year. In order to support losses from the illiquid holdings, Cathie Wood proposed selling the more liquid names, such as Tesla, to support the less-liquid holdings. One year later and returns of -45%, this potential solution should worry bag holders. After all, it is flows that move markets
2. In looking at Tesla and the S&P 500 Index, Tesla has a 2-year beta of 3.411. In terms of what gamma exposure suggests for SPX returns, I would certainly be nervous holding that type of risk knowing the underlying stock could swing by as much as 3 times the broader market. Events like Russia invading Ukraine or news that China is continuing to devalue and lockdown could be fuel to the fire.
3. Before Tesla invested in Bitcoin, it was already subject to the growing volatility regime. The company reported a $1.99 billion position in bitcoin at the end of 2021. Also, since then (year-to-date), Bitcoin has shed -15% of its value. Not only has Tesla become a levered growth play but now its price is tied to a cryptocurrency with an uncertain future. CNBC writes that Tesla does not account for Bitcoin as mark-to-market, which means only once Musk decides to sell will the implications materialize in earnings. This factor alone deserves its own post (stay tuned).
4. This Fed is hell-bent on beating inflation even while data already begins to roll over. Andreas Streno Larsen has put together some beautiful charts highlighting where the market is shifting (weekly earnings adjusted for inflation, oil price impact on CPI, discretionary spending, etc.). Also noted by Larsen: Biden desperately needs inflation to cool down to see approval gain steam from current levels. If the Fed throws him a bone, tightening could get uglier than most think.
Tesla has made a name for itself, whatever that may be for you. Regardless of whether you see Tesla as a visionary first mover in the electric vehicle industry or a ponzi scheme built by a meme of a CEO, the company is critical for markets. Tesla is the 5th largest company in the S&P 500, which means the implications of how Tesla functions is noteworthy. Its price action has become an indicator for what the broader macro picture looks like.
The company has been an option magnet for retail traders and smart money tracking flows, and whether or not this continues, the company is tasked with managing newer and potentially more problematic headwinds. With headwinds that face a company weighted this heavily in the S&P 500, the issues could grow. Now this is all known, but what better way to digest information than write?
If or when Tesla’s fate catches up with it, not only will Tesla find its way down with the “Magnificent 7,” but with Tesla’s drop should come with the broader index and Bitcoin. Tesla could be the perfect indicator for any contagion in markets. The question now is when that might be.