The recent performance of the ProShares Ultra QQQ ETF (NYSEARCA: QLD) reminded us of a very famous song by late music legend Prince:
I was dreaming ‘when I wrote this /So sue me if I’m going too fast/Life is just a party/And parties weren’t meant to last
So tonight I’m gonna party like it’s 1999
Source: Prince – 1999
The ETF targets daily investment results, before fees and expenses, that correspond to two times (2x) the daily performance of the Nasdaq-100 Index. Think of QLD as a Nasdaq on steroids. For every $100 of capital invested with QLD, an investor gets a move equal to $200 of capital invested with the Nasdaq-100 Index.
QLD has been on a tear lately – the vehicle is up +40% since June lows in the stock market. It seems like the sky is the limit these days for tech stocks and investors should start celebrating like it’s 1999! Should they now? We think not. Our article will go over some of the factors behind this year’s bear market, what has changed lately and where we think we are headed.
Low rates, high sugar for stocks
As the world crumbled during Covid, it seemed like everything we knew was going to change and all financial instruments had no bottom in sight. Then came the Fed. The list is very long when it comes to the actions they have taken in order to support the economy, so we will only mention a few points:
- reduce the federal funds rate to 0%
- engage in quantitative easing (QE), which means expanding the Fed’s balance sheet by buying Treasuries and MBS
- backed by money market funds
- various facilities to support the functioning of financial markets (summarized below)
By far the most important sustainable aspect for the economy has been the zero rate policy. This resulted in a “TINA” for equities and a general massive migration to risk assets. In a cruel twist of fate, Tina is also the slang for a highly addictive and hard to shake drug. It was the same with an accommodating monetary policy induced by the Fed during the Covid crisis. It was very difficult to shake both the investment community and the Fed. Much like a drug addict yearning for that enjoyable and rewarding “high”, we see massive stock market rallies whenever there is a whiff of low rates coming our way. Call it “Fed Pivoting”, “Peak Inflation”, “Recessionary Scare” whatever you want – let us translate these syntagms for your – “Low rates are coming!”. And there is nowhere else where these tremors are felt as strongly as in the technology sector. With companies that are exposed to high P/E ratios and long durations in terms of discounted cash flow valuation methodologies, low rates represent torrential rain from heaven during the drought season.
Higher rates for longer
With a stubbornly strong labor market, we believe the Fed has learned from past periods of stagflation and will hold rates higher for longer in order to bring inflation down for good. We are not saying here that rates will be at 4% for three years, but we believe that they will remain high (i.e. above 2.5% for the Fed Funds rate) for longer than investors think so. We are not going to see a Fed pivoting to extremely low rates again. We believe that the Powell shift in “neutral rates” actually indicates a long-term threshold that they consider appropriate for a new economic environment. In our view, a “soft landing” is not a warm, hazy economic environment where growth is high, inflation low, and everyone in the market is happy. Rather, we see it as an era of moderate unemployment, falling inflation and mild symptoms of recession (low to non-existent GDP growth, higher business default rates). If we examine how inflation will behave in various scenarios, we will notice that it will take some time for inflation to decline:
Most market participants are expecting a “Fed pivot” at some point, and presumably they are expecting a return to low rates. However, as the rates market is currently pricing, “low rates” is actually the Fed’s neutral rate of 2.5%:
We can see from the forward SOFR and Libor curves above that the rates market expects a return to the neutral rate of 2.5% somewhere in the spring of 2025, with higher levels until then.
We believe the ingredients for a tech “V” recovery are not there, and rates will reset at a higher pace going forward, with quantitative tightening also weighing on financial conditions and rates then that it begins to shift into high gear. in September.
We believe the current massive Tech rally from the June market lows is the result of oversold technical conditions, early signs of cooling inflation and client wishful thinking continuing the “hot” trades of the past. recent. We don’t think the ingredients that have pumped so much capital into the tech sector over the past few years are no longer there (very low rates, TINA effect, lure of gamma squeeze deals). Our view is that we are seeing a relief rally where the market finally gets some indication of what the fed funds rate peaks will look like, it finally sees a cooling in inflation and earnings are better than expected. reduced. Going forward, the market will no longer be able to feed on relief, but will look for growth and profits again. We are of the view that the relief rally will be followed by further weakness and higher VIX levels (the VIX has just fallen below 20) as the market will begin to slowly price in a “sticky” inflation scenario. “, higher rates for longer, a weaker consumer credit environment, and the Fed’s propensity to continue its fight against inflation even at the cost of prolonged mild inflation. From this perspective, QLD holders would do well to take what the market gave them in July and wait for a lower entry point going forward as the market digests the new macro setup.
The vehicle is up more than +40% since its June lows:
We can see the vehicle hitting its reported leveraged daily return, with the ETF (XLK) up “only” nearly 20%, while the S&P 500 is up just over 14%. at the time of writing this article.
However, the vehicle is still deeply negative since the beginning of the year:
The year-to-date chart is a stark reminder to investors that leveraged vehicles experience amplified violent movements when the primary market moves significantly over a calendar year. 2022 was the story of a market downturn.
QLD is a leveraged ETF that seeks daily investment results that are twice (2x) the daily performance of the Nasdaq-100 Index. The vehicle is up more than +40% since the market lows seen in June. We believe we are seeing a relief rally in the tech sector, driven by oversold technical conditions and the emergence of some “green shoots” in the macro setup, such as weaker inflation numbers, earnings above reduced expectations and a more concise picture regarding the highest level that Fed Funds can reach. Just like the famous 1999 Prince song “parties weren’t meant to last” therefore, we believe that the current state of euphoria will be followed by a return to “worry” trading as the new macro reality sets in.