9-4-24: Turning Volatility Into AI-Related Covered Call Trading Strategy

by Bryan Perry

September 4, 2024

Heading into September, the Mag 7 and other leading tech stocks have exhibited extreme volatility. In reviewing the chart action of the Round-Hill Magnificent Seven ETF (MAGS), it peaked on July 7 at nearly $50, then corrected 23% in three weeks and has since recovered roughly half of that loss.

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

There was a lot of technical damage done during this sharp and swift selloff, but most of the top seven holdings are showing more constructive price action of late, with the group setting up nicely to enter the fourth quarter, beginning October 1st, poised to retake a market leadership role.

For the past month, there has also been some bullish rotation into utilities (XLU), real estate (XLRE), financials (XLF), industrials (XLI), consumer staples (XLP), defense (ITA), materials (XLB) and gold (GLD). This broadening of the market is hugely constructive as the tech sector consolidates.

The advance/decline line for the S&P 500 has been very impressive during August, validating the broadening out and rotation into other sectors, which is highly supportive of a market that has the potential to rally further while still having to account for risks surrounding the presidential elections, the Middle East, China, and economic data such as this coming Friday’s widely anticipated employment data.

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

According to FactSet, for the current third quarter of 2024, 48 S&P 500 companies have issued negative EPS guidance, and 41 S&P 500 companies have issued positive EPS guidance. The S&P is currently trading at a forward P/E of 21x, which is above the 5-year average (19.4) and the 10-year average (17.9).

This premium I believe reflects the concentration of the Magnificent Seven stocks, which still dominate the top ten holdings of the SPDR S&P 500 ETF (SPY), making up 31% of the total assets. The market should continue trading at a premium, as these top holdings generate exceptional top and bottom-line growth.

It should be apparent to investors that the disruptive transformational changes and advancements being brought about by the implementation of Artificial Intelligence (AI) are not some temporary paradigm shift that has a half-life of 12-18 months. Big-name hyper-scalers will continue to spend the greatest aggregate amount of investment capital of all time on this technological revolution.

Even after these companies reported record sales and earnings attributed to AI-driven revenues, many on Wall Street and among investment and market professionals remain skeptical of the spending wave of future AI infrastructure. Therefore, it stands to reason that investors should source one of the soundest authorities in the business of research that covers the most extensive areas of technology cycles.

International Data Corporation (IDC) is a provider of market research data and advisory services focused solely on the technology industry. Founded in 1964, IDC’s analysis and insight helps IT professionals, business executives and the investment community make fact-based technology decisions and achieve their business goals. In a recent report, IDC estimated AI worldwide spending reaching $632 billion:

“Worldwide spending on artificial intelligence (AI), including AI-enabled applications, infrastructure, and related IT and business services, will more than double by 2028 when it is expected to reach $632 billion, according to a new forecast from the International Data Corporation (IDC) Worldwide AI and Generative AI Spending Guide. The rapid incorporation of AI, and generative AI (GenAI) in particular, into a wide range of products will result in a compound annual growth rate (CAGR) of 29.0% over the 2024-2028 forecast period.”

–Computer World, August 19, 2024

Eric Schmidt, co-founder of Schmidt Futures, and former CEO of Google stated, “I’m talking to the big companies and the big companies are telling me that they need $10 billion, $20 billion, $50 billion, $100 billion,” he said. Schmidt said OpenAI’s Sam Altman told him it’s going to take $300 billion to build out the required AI infrastructure. So, the AI train is not even close to reaching the next station.

If these forecasts are accurate, investors have another 3-4 years of leadership for the best-of-breed stocks that are leading the capital investment wave, but more importantly, the stocks of those leading companies providing the infrastructure for the ongoing buildout of AI. These are semiconductor manufacturers, semiconductor equipment manufacturers, semiconductor foundries, and network equipment manufacturers.

The list of these special stocks is not that deep, and they are volatile. One strategy would be selling out-of-the-money covered calls where option premiums are rich. Selling out-of-the-money covered calls on stocks like NVIDIA Inc. (NVDA) on short-term price spikes, investors can theoretically  take advantage of the volatility in the stock price.

With good timing – and it’s all about timing – one can sell 30–45-day calls into selected rallies and take full advantage of this volatile market. Long-term investors might consider selling calls on half positions so as not to risk having one’s entire position called away. This 5-6 year AI spending boom should provide opportunity found in no other sector of today’s market.

Navellier & Associates owns Nvidia Corp (NVDA), and Alphabet Inc. Class A (GOOGL), in managed accounts. Bryan Perry does not own Nvidia Corp (NVDA), or Alphabet Inc. Class A (GOOGL), personally.