The Invesco QQQ Trust ETF (NASDAQ:QQQ) is without a doubt one of the most popular choices among investors looking to ride the wave of momentum and participating the generative AI hype.
Over the past year, the ETF has done a great job at outperforming not only the broader equity market, but other growth and momentum oriented funds. Without accounting for dividends, the QQQ delivered a 44% return over the past 12-month period when the S&P 500 (SP500) (SPY) appreciated by 31%.
There are two important observations that should be made from simply looking at the graph above. Firstly, the last year was a very unusual one for equities as an asset class and investors should not expect a repetition of those returns over the next 12 months and beyond. Secondly, the vast majority of returns occurred since November of last year, when the U.S. Treasury published its quarterly refunding announcement (more on that later).
Although the top 10 holdings of the QQQ are all stocks that investors could hardly envision as a group that could deliver poor shareholder returns, the recent price action has significantly reduced the odds of that happening.
Moreover, in spite of their exceptionally large size, 4 out of the 10 companies in the group have a total return on capital of less than 10%, which is a red flag when it comes to evaluating the quality of their business model.
All that aside, the spectacular performance of the QQQ over the past year was mostly driven by outside factors that are unlikely to have the same impact on performance in the coming years.
A Wave Of Optimism
One of the major developments in recent months was the significant drop in probability of recession in 2024. The annual change of the Leading Economic Index (LEI) is now heading in positive territory and investors are increasingly betting on a strong economic recovery in 2024.
Based on the LEI the risk of a recession has not gone away completely, but the market has already made its move with the highly cyclical sectors of the economy delivering high double-digit returns, when consumer staples and utilities are at the very bottom of the performance ranking.
The Shiller P/E ratio is once again flirting with its recent highs of 2021 which were followed by a disastrous year for equities in 2022.
This performance is a clear indication that the market is not pricing in a major economic slowdown anytime soon and has moved in the opposite direction of assuming a strong economic recovery in 2024.
On top of all that, monetary conditions remain loose, in spite of all the talk about monetary tightening. The long-dated treasury yields are now well-below their recent top from October of last year.
This leads us to the U.S. Treasury Quarterly Refunding Announcement from the early November of last year which marked the top in long-dated bond yields. During the QRA, the Treasury announced significantly lower share of long-dated bonds to be issued in the coming months which was a strong signal of lower supply ahead. This resulted in higher prices and lower yields for those bonds which in turn stopped the yield curve steepening process (see the red arrow in the graph below).
In the meantime, the Federal Reserve has been guiding the market towards higher rates on the front-end of the curve. For example, in December of last year, the market was expecting that the Federal target rate would be in the 3.75% to 4.00% range at end of 2024 (see below).
As of today, the year is expected to end at the 4.50% to 4.75% range - a notable increase in expectations over just three months.
This dynamic has kept the yield curve inverted with the more important rates at the back-end of the curve remaining low.
The Road Ahead
The highly supportive monetary conditions have been a major driving factor behind the recent performance of growth stocks through the lower term-premium. They were also enough to dispel the fears of a recession, which had a double whammy impact on performance of the QQQ.
Thus, on one hand earnings expectations for the cyclical areas of the market have improved, and on the other high growth stocks benefited from lower than initially expected term premium.
To illustrate the impact of the latter factor, on the graph below, I have plotted the indexed performance of the QQQ minus that of the iShares MSCI USA Value Factor ETF (VLUE) - the blue line below. Against that we have the yield curve of the 10-Year Treasury (US10Y) minus the 3-Month Treasury (US3M), both in constant maturity.
Although the yield curve has steepened over the course of 2020, the unprecedented liquidity provided during the year has brought down 10-year yields below 1% which was a much stronger tailwind for growth stocks than it was for value back then. In the years that followed, the performance of QQQ vs. VLUE has gone in the other direction, up until the beginning of 2023.
The reason for this significant outperformance of QQQ vs. VLUE since early 2023 was the inversion of the yield curve in the last months of 2022. Thus, as the yield curve went deep in negative territory, the QQQ began its ascend in relative terms to the VLUE.
However, this tailwind is now appears to be largely exhausted as the yield curve inversion seems to have come to a stop and is slowly headed towards steepening once again.
In addition, in terms of actual business performance, the market is currently pricing-in significant revenue growth rate for almost all of the Top 10 Holdings of the QQQ. Unless these companies deliver growth rates in the excess of 10% to 20% over the coming year (for Nvidia (NVDA) in excess of 70%), then a further multiple repricing opportunity solely driven by business fundamentals appears unlikely.
There's always a possibility that the companies above deliver higher growth rates on the back of a strong rebound of the economy, however, given their size this appears unlikely. And with the term premium tailwind now largely exhausted, the prospects of the QQQ continuing to perform as it did in the past 12-month period are close to zero.
Conclusion
Following one of the strongest 12-month periods for the QQQ, I see little to no room for further gains through the rest of 2024. On the one hand we have the market already pricing-in a significant rebound in the U.S. economy and no recession occurring this year. This supports the ongoing revenue growth expectations of QQQ's major holdings. On the other hand, the highly supportive monetary conditions over the past year are no longer having the same impact on growth stock performance.
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