VTI - QQQ: Hold Until After The Fed's Next Meeting

2023-10-27 13:47:45 ET

Summary

• Investors should not join recent market selloffs ahead of the Federal Reserve's meeting next week.
• Risks in the tech sector, represented by the Invesco QQQ ETF, are much lower now than even ~3 months ago.
• QQQ’s valuation risks have dissipated substantially compared to the overall market.
• Furthermore, I expect the Fed to halt rate hikes.

Federal Reserve's Oct/Nov meeting in focus

For many investors, a key event on the agenda is the Federal Reserve Board's meeting scheduled for Oct. 31 - Nov. 1 (by the way, Happy Halloween!). The purpose of this article is to argue why investors should not join the recent market selloffs ahead of this meeting. I will use the Invesco QQQ ETF (QQQ) as an example to anchor my analysis to make it more concrete and tangible. However, I believe the results are applicable to other ETFs and sectors, especially those with a tech orientation.

A good way to encapsulate the gist of my thesis is by contrasting my current thesis to my earlier thesis. Back in early September 2023, my thesis was bearish, as you can guess from the title itself (see the chart below). I argued that QQQ and the tech sector, in general, were displaying the key signs that Ray Dalio used to identify bubbles, such as extremely high valuation, a discount of rapid future appreciation compared to benchmark rates, and broad bullish sentiment.

Now I see the risks from all these signs have dissipated substantially in the past two to three months. In the remainder of this article, I will elaborate on them in more detail. My key points will be:

1. I expect the Federal Reserve Board to halt rate hikes at its next meeting, thus easing the issue of rapid future appreciation expected in QQQ compared to benchmark rates.
2. My analysis shows that the valuation risks in the tech sector have dissipated substantially already compared to the overall market.
3. Finally, I see the current market sentiment as much less bullish than two to three months ago.

QQQ: Quick Introduction

QQQ probably needs no introduction. Here I will focus on a few key features directly relevant to the thesis. Since part of my thesis involves analyzing its valuation risks compared to the overall market, I will introduce these features by comparison to [[VTI]]. VTI tracks the CRSP US Total Market Index, which includes all US stocks, regardless of size or market capitalization. Thus, I will use VTI to approximate the overall market.

Compared to VTI, QQQ is much more top-heavy due to the dominance of a few mega tech stocks (the likes of Apple (AAPL), Microsoft (MSFT), Amazon (AMZN), et al). As seen in the chart below, the top 10 holdings of QQQ account for nearly half (48.89%) of the ETF's total assets. VTI, on the other hand, has a more diversified portfolio, with the top 10 holdings accounting for only 26.13% of its total assets. Both due to the degree of concentration and volatility behind tech stocks, QQQ has a significantly higher beta (1.22 in the past 24 months) than VTI (1.02).

Fed Oct/Nov meeting

Back to the Fed meeting. As aforementioned, I expect the Federal Reserve Board to halt rate hikes at its next meeting. I even expect a more dovish tone that could hint at the future reversal of rate hikes in this meeting. The key reasons for my expectations are two-fold.

First, the U.S. already has raised rates aggressively. The Fed has raised rates by close to 5 percentage points in the past two years. The current target range for the federal funds rate is among the highest levels of rates since 2008 and also the most aggressive among all major central banks (see the first chart below). The Fed now has to be concerned about over-tightening. If the Fed raises rates too quickly, it could push the economy into a recession.

Second, there are signs that the economy is slowing and inflation is cooling (see the second chart below). Recent economic data has shown that consumer spending is slowing and that the housing market is cooling. This suggests that the Fed's rate hikes are having the desired effect of slowing down the economy.

Valuation risks have dissipated substantially

Next, I will argue that the valuation risks in the tech sector have dissipated substantially even in the past two to three months due to the large corrections. I will use the yield spread between QQQ and VTI as a measure of the risk premium in the tech sector relative to the overall market as shown in the following chart. The yield spread shown here is calculated using the TTM dividends from QQQ and VTI and it's based on quarterly averaged prices.

Despite random market fluctuations, you can see that the spread is tractable and makes good sense. First, the spread always has been negative because QQQ concentrates on tech firms, which have consistently paid a lower dividend yield than the holdings in VTI. Second, more quantitatively, the spread has been in the range between about -0.75% and -1.25% the majority of the time during the past decade. Such a range provides a measure of the average risk premium of the tech sector relative to the overall market. When the spread is near or above -0.75%, QQQ is undervalued relative to VTI on a cyclical scale. A spread near or below -1.25% indicates the opposite.

That's a big reason why I was very concerned about QQQ back in September. The yield spread at the time was around -1.07%, very close to the lower bound of -1.25%. Now, due to the larger corrections, QQQ has suffered since then, the yield spread has recovered to about -0.87% (0.63% TTM yield from QQQ minus 1.50% from VTI), much closer to the long-term average.

Other risks and final thoughts

Finally, the current sentiment toward equity has swung too far in the fear extreme. As an example, the NAAIM Exposure Index (shown below) reported a rating of ~25 only for the week of Oct 25. For readers new to the index:

The index is an average of NAAIM member firms' reported equity exposure, with 0% indication a 100% cash or hedged to market neutral and 100% indicating 100% fully invested in equity.

A rating of ~25 is toward the most bearish end of the spectrum as seen. To provide another reference point, the average rating was a very bullish 70+ for the June-September quarter, which triggered my earlier article to examine the bubble risks.

In terms of downward risks, all market sector valuations are being pressured with risk-free interest rates hovering around 5% as seen in our sector dashboard below ( downloadable as a Google sheet). The tech sector is the most pressured sector in terms of yield spread relative to the 10-year Treasury rates. Readers familiar with our writing know that we are in general against the 60% equity-40% bonds template (or any other fixed allocation templates). However, given the current risk premiums of equity relative to bond rates, we think a 60%:40% template can make good sense.

But in any case, my bottom line is that this would be the wrong time to join the selloffs. It's OK to hold QQQ (or other similar assets) under current conditions. At least wait for the Fed's next meeting. The risks in QQQ have dissipated substantially compared to 2~3 months ago. To recap, my key reasons are threefold. First, QQQ's valuation risks in the tech sector compared to the overall market have now returned to the average level. Second, I see the current market sentiment toward the fear extreme. And finally, I expect the Fed to halt rate hikes at its meeting.

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