When I wrote about the Nasdaq tracker fund Invesco QQQ Trust ETF (NASDAQ:QQQ) in December last year, its year-to-date [YTD] performance had been notable. With a 54% rise, it had far outstripped the S&P 500 (SP500) index, which itself had seen a healthy 24% increase.
QQQ continues to inch up in 2024, with a 9% increase YTD. But here’s the twist. It has lost its edge over the SP500. In fact, it’s a shade behind the index (see chart below). It’s not hard to see why. Persisting macroeconomic risks and the fund's high valuation are likely catching up. This doesn’t mean that the impetus for forward movement has dried out, only that it looks relatively reduced now. Here’s how.
US economy strong but at risk of softening
First, consider the macroeconomy. So far, the US economy’s growth continues to surprise on the upside. The second estimate for GDP released last month reflects a 3.2% annual growth in the fourth quarter (Q4 2023). This is lower than the 4.9% increase seen in Q3 2023, but it’s still significantly higher than the trend growth of a little over 2%. For the full year 2023 too, GDP came in above trend at 2.5%. This in turn gives greater faith in the potential performance of equities in the near term at least.
Unless of course, growth does indeed cool down as much as forecast. In Q1 2024, it's expected to come in at 2.1% according to a survey of 34 professional forecasters, an over 1 percentage point softening from a quarter earlier (see table above). How far it plays out remains to be seen, though, for two reasons. One it has been significantly revised upwards from the previous forecast of 0.8% and two, for the full year 2024, the average projection is a 2.4% growth, which is just a tad lower than last year.
The forecasts imply that while there isn’t a serious threat to the economy from a slowdown this year, there continues to be a risk to equities' performance if it does indeed cool off.
Subsiding inflation and interest rates can support margins
Even if growth does slow down though, the edge can be blunted as inflation continues to reduce. Inflation has remained relatively mild, at 3.2% year-on-year (YoY) in February, this alone improves the chances of the economy staying on track for the rest of 2024. Moreover, with the number expected to come off to sub-3% levels this year (see link for the survey of professional forecasters above), the likelihood of interest rates declining later this year is high.
So far the Fed has resisted cutting rates as inflation has stayed above its target rate of 2% and the economy’s resilience has continued. But if the forecasts as noted above turn out to be accurate, slowing growth and lower inflation can result in interest rate cuts. This, in turn, is a positive for net margins, as the pace of cost increases slows down, particularly interest expenses.
Potential for increase in biggest holdings’ prices
On the biggest holdings, the story remains broadly the same as it was a quarter ago. First, the holdings remain the same even though the weights have been shuffled around a bit. Microsoft (MSFT), NVIDIA (NVDA) and Amazon (AMZN) now have bigger shares.
Of these, only Apple (AAPL) and Tesla (TSLA) have seen price declines YTD while the rest continue to rise (see table above). This isn’t something to ignore, though. In 2023, all the stocks had seen a price rise, with both Apple and Tesla contributing in no small measure, with increases of 55% and 134% in 2023 when I last wrote.
At the same time, it’s worth noting that in terms of valuation, the top 10 holdings still look alright. Here’s how:
- The average weighted P/E for these holdings has actually declined to 33.8x compared to 37.3x when I last wrote.
- Five of the top ten holdings are still trading below their five-year average price-to-earnings (P/Es). Of these, Amazon (AMZN) continues to look the most promising and a deeper analysis of the stock reveals that there’s still further upside to it in 2024.
- Despite four of the five top 10 holdings trading above their five-year average P/Es even in December, their prices have also continued to rise, indicating that they are valued relatively higher now.
The key takeaway here is that while there’s still scope for a further uptick in the key holdings, there’s also some risk of correction going forward, as already evidenced by the recent performance of two of these stocks. Also, Since the last time I checked, the ETF’s P/E as a whole has inched up from ~33x to 34.4x. It also remains higher than that for the S&P 500 at 28.4x.
Of course, the holdings will likely change if there are underperformers among the top then, which in turn assures a level of returns for QQQ. The fund's price returns of 412% over the past decade are an indication of its superior performance over time.
The question of consumer discretionary demand
The fact that the fund’s YTD returns at 9% are lower than the weighted average returns of the top 10 holdings at ~22% reflects that the drag comes from other sectors. The consumer discretionary sector, the ETF’s second biggest sector holding with a share of 19%, is the likely reason. The S&P 500 Consumer Discretionary Index risen by just 4% YTD. The sector can remain a weak spot for QQQ going further into 2024 if growth cools off as forecast, even if dramatic declines are ruled out.
What next?
In sum, though, there's some potential for QQQ can continue to rise for the rest of 2024 based on the performance and valuations of its top 10 holdings. It also helps that inflation is subdued, interest rates can come off and the US economy’s hard landing is pretty much ruled out.
But the economy might still cool off, particularly in the ongoing quarter. In fact, two of the top 10 holdings have seen a come-off in price YTD as opposed to all 10 seeing good returns the last I checked. The consumer discretionary sector’s lacklustre YTD price growth is also an indication that this second-largest sector holding can be a drag on the returns.
On balance, there's a reduced probability of strong growth in 2024. Its long-term returns, however, are notable as are the credentials of its biggest holdings. Investors with a medium to long-term time horizon are likely to benefit more from an investment in the fund now than those looking for relatively short-term returns. I’m retaining a Buy but with a longer-term holding period in mind.
