PSQ - Market Fatigue Explains QQQ's Relative Resilience And Should Benefit PSQ

2023-03-09 09:10:03 ET

Summary

• A comparison of the performance of Nasdaq-100 tracking QQQ in 2018 and 2023 reveals that the market is behaving irrationally given the higher risk level this year.
• This irrationality can be attributed to "market fatigue" and helps to explain the Nasdaq's resilience.
• However, fatigue also implies that something has to give up, which should be beneficial for those wanting to short tech with ProShares' PSQ.
• I also elaborate on the risks of using this shorting tool.
• To kick off, the convergence between Fed Fund rates and inflation provides a hint of what is to come.

The chart below shows the Federal Funds rates, and U.S. inflation, both headline and core are starting to converge. Looking at the rear mirror, one can also see that the same happened towards the end of 2018, more precisely around October.

As I will elaborate upon, this convergence coincided with a downturn in the stock market. Building on this knowledge as well as some of the moves by the U.S. central bank and certain economic indicators, this thesis will first show how the resilience of the tech sector, namely, the Invesco QQQ Trust ( QQQ ), is all due to market fatigue. Secondly, I assess whether this is an opportunity to short tech stocks using ProShares Short QQQ ETF (PSQ).

I start by providing an overview of the situation in 2018 when President Trump was at the White House and Jerome Powell at the Federal Reserve.

Comparing QQQ's Performance in 2018 and 2023

The first nine months of 2018 were not too bad for the stock market, as, despite some initial losses, QQQ still evolved amid one of the longest bull runs in history, until things turned ugly in October when it fell by over 20% as pictured below.

The situation is not very different today with QQQ suffering from an above 20% downside earlier this year before recouping part of the losses as shown below. Just like in 2018 , these stock market pains come despite signs that the economy is doing well with record low unemployment, this time, despite the Fed having applied the brakes by four 75 basis points hikes from June to December last year.

Two differences between now and then were the relatively low inflation in 2018 with interest rate raises effected at a much more modest pace.

At that time to justify the fourth hike in 2018, the Fed Chair had said that the American economy had never been doing so well since the Great Recession. However the announcement for the 25 basis points raise made on December 20, 2018 did not please the financial markets which were expecting a more dovish tone from the U.S. central bank and stocks began to nose dive as soon as the rates decision was announced, with the S&P 500 ultimately losing 1.5% and closing the day at its lowest level since September 2017.

Looking specifically at QQQ, there was a 16.73% fall in the value of the Nasdaq-100 tracking ETF from December 3 to December 24 2018 as shown below, a period marked by rising rates together with a tighter monetary policy outlook for 2019.

The Irrational Market Behavior

Now, compare this with QQQ's underperformance of only 1.52% in the period following the January 31 hike of 25 basis points which brought the effective fund Fed rates to 4.75%, compared to near zero only one year ago. This period includes Chairman Powell's recent testimony on Capitol Hill , where he declared that the fight against inflation was far from over and that he is prepared to hike the pace of interest rate hikes, if necessary.

This market behavior appears to be irrational given that GDP growth will also slow to 0.3% in 2023, or ten times less than in 2018 together with the fact that no rate cut should be expected in 2023. Also, with government debts at a record level and high inflation still on the agenda, the Fed does not have the necessary leeway to use interest rates to address a protracted slowdown in the economy.

Now, while some attribute this state of affairs to logarithmic trading and others to the wall of money-supporting equities, my point of view is that this irrational market behavior is rather due to market fatigue, not complacency.

Market Fatigue

Learning from psychology , the fatigue effect is the decline of performance because participants experience a task time and time again and when subject to various factors like different light or noise levels.

In the same way, the stock market is synonymous with carrying more or less the same tasks lasting for years, and where investors and traders alike are subjected to factors like interest rates being hiked or lowered, economic growth which is currently flip-flopping between soft-landing and hard-landing, and the Fed's Chairman oscillating between hawkishness and dovishness. Thus, they are prone to fatigue effect. For this matter, the impending economic contraction has been termed ' the most telegraphed recession ', ever since the Fed began to rise rates in 2022 and, as a result, many have come to doubt whether it will materialize at all. Along the same lines, the yield curve is inverted, but, this has been the case since July 2022 !

To provide further justification, this fatigue is evident both in the volumes of QQQ shares traded on a daily volume (in blue) relative to SPY in orange as per the chart below. Here, investors will note that the divergence between QQQ and SPY toward the right-hand side shows that tech shares are being traded relatively less compared to stocks forming part of the S&P 500.

To further confirm this reduction in interest in tech, as shown by the black trend line below, the daily difference between QQQ's high and low has decreased from around $10 in March 2022 to $4 this month, suggesting less intense trading activity, while it should be the contrary because of the flurry of news hitting the market.

Now, the very idea of fatigue means that at some point the market will have to give away, and for this to happen, one of the catalysts could be the Jobs report on Friday.

Profiting through PSQ but Beware of Risks

The report, more specifically whether wages rise or slow down, or employment growth gets hampered as a result of higher rates, will be the real determining factor as to the Fed's degree of hawkishness going forward. However, bear in mind that if the numbers are strong, rates should move higher for longer. Otherwise, it may still be moving higher as inflation remains high, but, for a shorter period.

Now, in either case, economic activity is being slowed down at an unprecedented pace as a result of higher borrowing costs, with the full effects still to come. One of these will be on profitability, with analysts projecting earnings declines of -5.1% and -3.3% for the S&P 500 for Q1-2023 and Q2-2023 respectively.

Consequently, with tech constituting more than 27.6% of the S&P 500 index and earnings forming the denominator of Price/Earnings, expect the ratio to go down in 2023 as share prices go down to reflect the decline in earnings. Moreover, further pain for the tech sector is also justified by QQQ's price/earnings ratio of 22.71x , being higher than SPY's 21.72x . Along the same lines, as seen by the massive layoffs , it may also be difficult for tech companies to achieve growth targets, as the focus is on cost-cutting. Add to this the difficulty to raise equity capital due to higher borrowing costs, and investors looking for inflation-beating returns in "safer" asset classes, then you also have liquidity risks for companies with less healthy balance sheets.

Therefore, the ingredients which can trigger a downside in tech are present and PSQ is a means to profit from such a move. Thus considering a 4.2% (average of 5.1 and 3.3) decline in the value of QQQ, PSQ which provides inverse exposure ( -1x ) to the Nasdaq-100 index, should rise to around $13.75 (13.22 x 1.04).

This remains a moderate target due to the fatigue effect which provides underlying support for tech and also due to the fact that for the second half of this year, analysts are predicting earnings growth averaging 6.75% for the S&P 500.

On a cautionary note, investors will also note that due to the compounding effect inherent in leveraged funds that provide inverse multiples, returns can be significantly different than the target return. This is the reason ProShares advises calculating returns over periods not exceeding one day. This risk is also singled out by Seeking Alpha .

Also, with relatively high fees of 0.95%, PSQ is prone to ETF decay , or falling in value over time as shown in the chart below, and, thus, avoid buying and holding at all costs as per recommendation by the Securities and Exchange Commission .

Still, when compared to highly leveraged like the ProShares UltraPro Short QQQ ( SQQQ ) which requires much more of a trading profile and where the trade has to be monitored rigorously, PSQ can be traded over a relatively long period as the 0.99% dividends paid can attenuate part of the losses.

Conclusion

Therefore, by going through the performances of the Nasdaq-100 tracking QQQ during 2018 and at the current juncture, this thesis has shown that investors are behaving irrationally, a phenomenon that can be attributed to market fatigue. At the same time, after some earnings decline in the first half of this year, things should improve which makes it unlikely for QQQ to fall by much unless there is a recession or faults start to appear in credit.

Furthermore, those cost-cutting moves by big tech which constitute over 50% of QQQ's holdings as pictured below should start to positively impact earnings from the second half of this year.

Finally, as for PSQ, the idea is to profit from market fatigue giving way to tech sell-off, by shorting QQQ which is relatively overvalued when compared to the broader market, but, do not expect large gains. Also, in view of the compounding risks involved, it is better to trade depending on favorable market conditions like the publication of the Jobs report on Friday or the start of tech earnings season in April.

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