2023-03-27 03:09:40 ET
Summary
- The Fed is still committed to the 2% inflation target.
- Thus, the Fed-induced recession is likely imminent, with the banking crisis acting as the major catalyst.
- The next leg lower for QQQ is likely approaching.
The bearish thesis
The bearish thesis for Nasdaq 100 ( QQQ ) is simple : tech stocks are still overvalued (with the PE ratio at 25), facing a likely deep recession. As the recession gets priced in, the tech earnings will get downgraded, and the valuation multiple will have to contract, implying a significant downside potential.
The effect of the banking crisis
However, the unfolding banking crisis made the QQQ bearish thesis more uncertain. Specifically, the market now expects that the Fed to lower the interest rates, which is on-the-surface bullish for tech stocks.
Essentially, the Fed is now faced with the difficult choice a) continue to focus on inflation and keep the monetary policy restrictive until inflation returns to the 2% level, or b) refocus on the financial stability issue and loosen the monetary policy.
Given the historical episodes, like the Long Term Capital Management collapse in 1998, there is a significant risk that the Fed actually chooses the financial stability, which would be near term bullish for tech stocks, like it was in 1998. Thus, heading into the FOMC meeting last week (March 22), I felt it was prudent to enter as neutral on QQQ.
But after the Fed meeting, it is obvious that the Fed is still concerned primarily with inflation. In fact, the banking crisis is the result of the Fed's strategy to induce the tighter credit conditions and ultimately a recession - to ensure that inflation returns to the 2% level.
Specifically, the Fed can induce a recession by inverting the yield curve - by pushing the Federal Funds rate well above the long-term rates. In this situation, the banks are not supposed to be able to make profits on lending, which tightens the credit conditions.
But during the current tightening cycle, the banks did not play along as the Fed was increasing the interest rates - the interest rate on the deposits remained near 0 percent, while the Federal Funds rate approached the 5% level. This allowed the banks to have significantly higher net interest income - by paying near 0% on deposits and lending at much higher rate. See the chart below, banks currently have 30% higher net interest income from the year ago. Banks got greedy and that's actually going against the Fed.
FRED
The bullish scenario for QQQ is also simple: the Fed accept a higher level of inflation and loosens the monetary policy to ease the banking crisis, which has a double positive effect on QQQ: 1) lower interest rates allow for higher PE ratio, thus the liquidity-based selling eases, and 2) a looser monetary policy would actually reduce the probability of a recession, which would ease the concerns about the tech earnings downgrade. Essentially, the tech bubble reinflates.
But after the Fed meeting, it is obvious that the Fed will not allow for a higher level of inflation - it remains committed to the 2% target. Thus, the Fed does not plan to cut interest rates - as long as inflation is well above the 2% level.
Further, the Fed does not plan to cut interest rates until the unemployment rate increases to at least 4.6% - as this would ensure that the "sticky" service ex housing inflationary pressures ease.
Thus, the Fed does not plan to cut interest rates until the recession arrives. That means, the expensive QQQ valuation multiple has to contract, and the tech earnings will have to be downgraded - implying the significant downside potential for QQQ. Consequently, I resume the bearish view with the sell rating on QQQ.
To make the things worse, the upcoming recession could deepen the banking crisis from what is currently just the liquidity crisis, to a full-blown credit crunch based on bad loans.
The Fed promised "some pain" and the pain is just starting - and it ends with 4.6% unemployment and a recession. So, when is the recession coming? The banking crisis is definitely a catalyst. The near-forward spread is saying the recession is imminent. But it all depends on the labor market, and we should start seeing an increase in the weekly unemployment claims over the next 2 months.
Recent QQQ performance
The Nasdaq 100 ETF QQQ is up by 17.55% YTD. If you look at the long-term chart, QQQ is bouncing off the key 200wma support, trying to reach the key 100wma resistance. The next big move in QQQ will be the 200wma breakdown or the 100wma breakout - and I'm open minded for both scenarios. However, based on the current situation, as I explained in this article, we are more likely to see the next leg lower with the 200wma breakdown towards the pre-covid levels.
Barchart
The big tech rotation
Nasdaq 100 ETF QQQ is composed of tech stocks ( XLK ), with 25% of the weight in Microsoft ( MSFT ) and Apple ( AAPL ), consumer discretionary stocks ( XLY ), with about 10% in Amazon ( AMZN ) and Tesla ( TSLA ), and communication stocks ( XLC ) with about 11% in Alphabet ( GOOGL ) and Meta ( META ). So, these large cap stocks represent about 45% of QQQ.
In 2023 YTD, there was a major rotation into these QQQ stocks, based on the assumption that inflation is falling faster than expected, and the Fed pivot is imminent. Broad market index S&P 500 ( SP500 ) is up by 3.42%, but it's driven mostly by the QQQ stocks, with communication and technology up around 18% and discretionary up by 9%.
More importantly, the rotation in "speculative" risk-on tech stocks came from the "safe" risk-off stocks, with health care ( XLV ), utilities ( XLU ) and staples ( XLP ) all down for the year. Interestingly, the worst performing sector was energy ( XLE ), down by 10%, which is perhaps the strongest indicator of the upcoming recession.
SelectSectorSPDR
The alternative way of looking at the recent market performance, is that traders simply took profits on the 2022 trades, by selling the winners (energy) and covering the shorts in QQQ stocks, which fell the hardest in 2022, and is still well off the highs.
Tactical considerations
The next leg lower will likely be a recessionary trade, and QQQ is vulnerable given the high valuation. Thus, QQQ seems at the level where the short positions could be reinstated but considering the possibility that the current "bounce" could extend to the 100wma at the 328 level, which is 5-6% above the current level. Tactically, the trigger for a much deeper selloff will be below the 286 level, which is 7-8% below the current level.
For further details see:
QQQ: Next Leg Lower Approaching