QQQ - QQQ: Strong Sell On Bubble Indicators

2023-06-21 20:00:49 ET

Summary

• Ray Dalio's bubble indicators are flashing ~ Retail investors are very long tech.
• AI may benefit some tech stocks and be a problem for others.
• Amazon, Apple, Nvidia, Microsoft, Google, Meta, and Tesla all have issues, and they make up 55% of QQQ's assets.
• I am downgrading QQQ to a "Strong Sell" with prospective returns of 2% per annum.

Artificial Intelligence

Following the reveal of ChatGPT, many have seen the whites of the eyes of the AI revolution. The result: The Invesco QQQ Trust ETF (QQQ), which tracks the Nasdaq 100 index, is up 38% year-to-date:

However, AI has always been a significant part of our future. In this regard, nothing has fundamentally changed. I discussed AI at length in my first article on the S&P 500, dated June 2022. Here's a snippet:

"Artificial intelligence is another boon for business -- This is just the beginning."

Looking at how AI will affect QQQ's businesses, I see it as a net benefit for some and a net detriment for others. For example, Google ( GOOG ), at roughly 8% of QQQ's assets, has seen its search engine exposed by ChatGPT. ChatGPT provides users with quick, albeit occasionally unreliable, answers. In my experience, Google's search results are often poorly correlated to the question being asked. This raises questions surrounding Google's future, in my opinion.

On the other hand, there are AI winners, including the obvious ones: QQQ's Nvidia ( NVDA ) and Microsoft ( MSFT ), which now have exuberant valuations. But, I think the real winners are the old-age companies. These companies can use AI to improve the efficiency of their operations and, potentially, their profit margins.

The Thesis

With bubble risks elevated, I am downgrading QQQ to a "Strong Sell."

Dalio's Bubble Indicators

One of the most important things one can do in investing is to avoid bubble assets. Is QQQ a bubble? Let's take a look under the hood.

Ray Dalio judges stock market bubbles based on six indicators . I will analyze the first five:

"How high are prices relative to traditional measures?"

Apple and Microsoft are QQQ's largest holdings ( 25% of assets). They have become more expensive over the years.

Price to operating cash flow per share:

So, 25% of QQQ's holdings are much more expensive than they were in the past. What about the other 75%? Well, we know that the Nasdaq 100 traded at a CAPE Ratio of 34x at the end of 2022; the CAPE ratio uses 10-year average earnings, inflation-adjusted. With the recent parabolic rise, I calculate the Nasdaq 100 now trades at a CAPE ratio above 45x. This has historically resulted in negative real returns over the next 15 years:

So how expensive is a CAPE ratio of 45x in the context of history? Well, over its 150-year history, the S&P 500 has had a median CAPE ratio of just 16x . QQQ is roughly 3x more expensive than this.

"Are prices discounting unsustainable conditions?"

Over the next ten years, I estimate QQQ businesses can grow earnings at 8% per annum, with the fastest-growing businesses offsetting those that decline. I see some headwinds in terms of higher corporate taxes, peaking profit margins, a deglobalizing world, structurally higher interest rates, higher unemployment, and slowing government spend. I have discussed these issues at length in previous articles on the S&P 500 and the Nasdaq 100 .

In the decade ahead, I estimate returns of 2% per annum (Compounded) for QQQ:

Note: This is a base-case estimate. Current EPS is based on year-end 2022 numbers. The compound annual growth rate is for dividends and earnings.

A 2% nominal annual return quickly becomes a negative real return if we adjust for inflation. I see QQQ as a buy at $230 per share (Implying returns of 7.5% per annum with dividends reinvested). This represents nearly 40% downside.

"How many new buyers have entered the market?"

Morgan Chittum of Business Insider recently reported:

"Average retail investor allocations are very concentrated and largely titled towards tech stocks. Nearly 30% of retail portfolios are in Tesla and Apple, along with 10% in other mega-caps like Nvidia."

So, retail investors have certainly entered QQQ names. With similar findings by Visual Capitalist:

Many of these retail investors got their start in 2020. Still, retail participation is elevated:

I see this level of retail participation as unsustainable and a function of 50-year lows in unemployment .

"How broadly bullish is sentiment?"

When it comes to Nasdaq names, my observation is that investors are very bullish. In recent months, rosy big tech stories have been plastered all over CNBC. As for the broader market, bullishness has increased.

The AAII Sentiment Survey shows 45% of investors are bullish on the next six months, while just 23% are bearish:

This compares to the historical averages of 38% bullish and 31% bearish.

"Are purchases being financed by high leverage?"

I see no issues here. For the most part, QQQ businesses have good balance sheets and are financing purchases with cash flow and/or share dilution.

As for investors, margin debt as a percentage of the stock market is at very low levels. And, for good reason, it doesn't make sense to borrow money at 5% and use it to buy businesses with a 3% earnings yield.

Margin debt as a percentage of the Wilshire 5000:

A Bottoms-Up Approach

The above six stocks make up nearly 50% of QQQ's holdings. They have one thing in common; they do something exciting and futuristic. I have analyzed five of these six stocks but choose not to own them. I have a number of concerns, including stock-based compensation, capital allocation, and duration of cash flows.

Stock-Based Compensation

Many Nasdaq businesses have exaggerated cash flows due to stock-based compensation. For example, Amazon ( AMZN ) is using $21 billion of stock-based compensation, and Meta Platforms ( META ) is using $12.5 billion. In comparison, a company like Berkshire Hathaway ( BRK.B ) uses zero stock-based compensation. This stock-based compensation is good for executives (CEO's), but often bad for shareholders because it tends to dilute their per-share ownership of the underlying company.

Capital Allocation

Looking at capital allocation, Amazon ( 7% of QQQ assets) has sky-high depreciation costs due to its investments in depreciating movies, planes, and delivery vans. This depreciation is accounted for in earnings, contributing to Amazon's PE Ratio of 299x.

Apple ( AAPL ) and Microsoft are spending huge chunks of their cash flow on share repurchases. Buying back shares at a 3% earnings yield probably isn't the best use of capital.

Meanwhile, Tesla ( TSLA ) has continued to dilute shareholders despite having ample cash on its balance sheet and even invested in Bitcoin at the peak in 2021. On the other hand, Meta has spent $36 billion on the Metaverse "with little to show for it," according to Business Insider .

Duration Of Cash Flows

My main concern with a company like Apple ( 12% of QQQ assets) is the duration of its cash flows. Apple is a consumer technology business. Consumer tech businesses do not remain dominant forever; just look at Nokia ( NOK ), GoPro ( GPRO ), BlackBerry ( BB ), Sony ( SONY ), Xerox ( XRX ), and Polaroid.

Sectors And Weightings

It should be noted that not all QQQ businesses are technology businesses. The Nasdaq 100 index also includes businesses like Pepsi ( PEP ) and Costco ( COST ). However, QQQ's other sectors, such as Consumer Discretionary, are dominated by "tech" businesses like Amazon, Activision Blizzard ( ATVI ), Booking Holdings ( BKNG ), Airbnb ( ABNB ), Tesla, and Netflix ( NFLX ).

Risks To The Thesis

As I explained in my August 2022 article on QQQ, "Crazy things can go on longer than you expect. In 1989, the P/E of the Japanese index reached 60x earnings." This is reason enough not to short QQQ, and is why I have never shorted a stock/ETF. I prefer long-term bets; In the short term, Mr. Market is prone to irrational swings, representing a risk for something like the ProShares Short QQQ ETF ( PSQ ).

This is a 10-year thesis that focuses on the fundamentals and what the underlying businesses may earn. I previously wrote an article entitled "S&P 500 And Nasdaq 100: Beware Peak Earnings." The S&P 500's Q1 2023 earnings have since fallen 27% year over year, yet the S&P 500 and Nasdaq 100 have rallied:

This seems to have occurred for three reasons: Exuburance surrounding AI, speculation that the Fed will lower rates, and the resilience of retail investors due to low unemployment in the United States.

Looking at the long-term, there is a possibility QQQ businesses compound earnings faster than 8% per annum. Some QQQ businesses appear to be under-earning right now. For example, Amazon and Advanced Micro Devices ( AMD ). There is also a chance the macro plays out better than I expect.

Next, there is my 17.5x terminal multiple, which contributes to my outlook for negative real returns over the next ten years. If interest rates are low and expected to stay low in 2033, my terminal multiple for QQQ may be too conservative. Over the past decade, interest rates have been at a 5000-year low:

I assume an interest rate of 5% in 2033. This is a bet on reversion to the mean.

The Bottom Line

Ray Dalio's bubble indicators highlight the risk at play for QQQ. Retail participation is elevated, sentiment is bullish, valuations are stretched, and prospective returns are low. A bottom-up analysis points to problems ahead for QQQ, which has 55% of its assets in seven stocks. To side-step this potential bubble, we have cut technology holdings in favor of old-age companies that may be equal beneficiaries of AI. For more on this strategy, consider subscribing and having a look at my "Strong Buy" articles.

Until next time, happy investing!

For further details see: