XLY - QQQ: Rising From The Ashes

Summary

• Investors have a front-row seat to witness the epic battle for AI supremacy as Microsoft and Google, the dominant holdings in the QQQ ETF, vie for dominance.
• As a leading holding in the QQQ, Nvidia lays the foundation for the AI ecosystem, positioning itself at the forefront of the industry's most exciting and rapidly advancing technology.
• The QQQ has outperformed the Dow Jones Industrial and S&P 500 in 2023.
• Despite the Federal Reserve's hawkish outlook, could the outperformance of the QQQ continue to defy expectations and soar even higher?

Thesis

The Invesco QQQ ETF ( QQQ ) started life well in 2023, as it outperformed the S&P 500 ( SPX ) ( SPY ) and the Dow Jones Industrial ( DJI ) ( DIA ).

Hence, investors have continued to lift the gloom over the tech-heavy QQQ, despite the recent layoffs by Microsoft ( MSFT ) and Google ( GOOGL ) ( GOOG ), joining Amazon ( AMZN ) and Meta Platforms ( META ) in their endeavor to slash costs.

The QQQ's revival could have surprised some tech bears over the past three weeks. Notably, enterprise IT spending has continued to come under further pressure, coupled with cuts in capital spending .

Therefore, the tech headwinds that faced the QQQ have carried on from 2022 as investors parsed whether it's time to return to growth stocks within the QQQ that have outperformed the S&P 500 over the past ten years.

The media headlines streaming in do not seem to favor a re-rating in the QQQ. However, we believe that significant pessimism has been reflected, which is also supported by QQQ's price action.

As such, we urge investors not to fear the downcast news but focus on the underlying secular growth drivers underpinning the leading holdings of the QQQ, particularly in AI.

Buy QQQ To Gain The AI Edge

The QQQ is a tech-focused ETF. However, what's likely less known is that the leading constituents in the QQQ have an AI edge. As such, investors could benefit tremendously from the diversification by buying the QQQ if they are unsure who the winners could be.

Leading holdings in the QQQ ETF. Data source: YCharts

The leading constituents in the QQQ have invested significantly in AI. The top eight holdings comprise nearly 47% of the ETF's weight, lending investors considerable exposure to the benefits of their investments in AI.

As such, investors can leverage the ETF as a core exposure without the need to decide on who could win among these holdings.

But why the focus on AI now? Microsoft founder Bill Gates reminded investors recently:

AI is the big one. I don't think Web3 was that big or that metaverse stuff alone was revolutionary but AI is quite revolutionary. I am quite impressed with the rate of improvement in these AIs. I think they will have a huge impact. - Insider

Microsoft Or Google On Generative AI?

Microsoft CEO Satya Nadella highlighted that the pandemic-fueled corporate excesses are likely over, as he's "now seeing them optimize their digital spend to do more with less."

As QQQ's leading holding by weight, investors should be assured that Nadella & his team appears to be at the forefront of incorporating AI into its entire suite of products and services. We discussed in a recent article highlighting why Microsoft's investment in OpenAI has enabled it to capitalize on AI technology that Google has been reticent to embrace.

However, things may be starting to change pretty rapidly. Google stock's combined weighting of 7.47% places it right behind Apple stock as the No.3 holding by weight. Hence, investors in QQQ have a front-row seat in assessing the AI battles between Nadella and Google CEO Sundar Pichai.

In a recent GOOGL article , we discussed why Microsoft wants to disrupt Google's ability to grow its most promising growth driver in a challenging year for advertising. But, then, just when we thought Microsoft was gaining the upper hand against Pichai and his team, the NYT reported that Pichai invited Google's founders Larry Page and Sergey Brin back for critical AI product and strategy meetings.

According to presentation slides obtained by the NYT, Google is ready to amp up its launch cadence of AI into its search and other product features in 2023. Hence, we could witness one of the most exciting face-offs between two of QQQ's leading companies in their quest for AI dominance.

Notably, Google was said to be ready to "unveil more than 20 new products and demonstrate a version of its search engine with chatbot features this year."

Pichai also took the opportunity to assuage investors in his publicly released internal email to employees about the company's developments in AI. Accordingly, Pichai accentuated:

Pivoting the company to be AI-first years ago led to groundbreaking advances across our businesses and the whole industry. Thanks to those early investments, Google’s products are better than ever. And we’re getting ready to share some entirely new experiences for users, developers and businesses, too. We have a substantial opportunity in front of us with AI across our products and are prepared to approach it boldly and responsibly. - Message from Sundar Pichai

Hence, the stage is set for Google to take on Microsoft as the two tech behemoths contend for AI leadership.

Investors also shouldn't forget about the underlying infrastructure that supports the massive AI ecosystem. Stratechery's Ben Thompson made a critical point: " Nvidia's investment in the CUDA ecosystem means the company doesn't simply have the best AI chips, but the best AI ecosystem, and the company is investing in scaling that ecosystem up."

Hence, with NVDA as QQQ's fourth-largest holding behind AMZN, the AI arms race could favor a re-rating of NVDA if the market is satisfied that its consumer headwinds have been adequately de-risked.

AMZN has also seen a remarkable recovery in 2023, as investors have likely positioned themselves for a recovery in economically sensitive sectors like consumer discretionary. As the Consumer Discretionary Select Sector ETF's ( XLY ) most significant holding by weight, AMZN's performance has a considerable bearing on the XLY's performance.

Recent backtesting data on the XLY seems optimistic, suggesting that further gains could continue to follow. Therefore, it could indicate that investors are likely assured that a deep recession could be avoided.

Moreover, Morgan Stanley ( MS ) Investment Management sees a strong rebound in battered sectors like consumer discretionary, suggesting that the pessimism could have been overextended in 2022.

Hence, the QQQ's recent outperformance against its leading index ETF peers could have further momentum, given its significant underperformance in 2022.

Takeaway

Generative AI could still be a hype that may fail to live up to its billing. Despite that, its public preview through the launch of ChatGPT has proved to be relatively successful, spurring Google to catch up on its product launch cadence. Hence, investors not sure about which AI company to invest in can consider leveraging the QQQ as a core exposure.

Notwithstanding, investors looking to add exposure should continue paying attention to the Fed's messaging. We assessed that the market has likely priced in an earlier-than-expected Fed pivot . However, Fed officials have consistently maintained their commitment to combat inflation. As such, we have yet to glean that the Fed is ready to reverse the direction of their rate hikes, which could carry some nasty surprises to the downside.

Therefore, it may be prudent for investors to remain cautious, adding exposure over time and benefiting from potential downside volatility to improve their reward/risk.

Rating: Buy (Reiterated).

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