Is QQQ A Buy Or Sell During The Dip? It’s Complicated

Introduction: Why Is QQQ Declining In 2022?

Invesco’s QQQ (NASDAQ:QQQ) is an exchange-traded fund that tracks the tech-heavy Nasdaq-100 index. Over the last decade, technology stocks have been riding high on the back of a secular bull market, and QQQ has proven itself as a great tool to make a concentrated bet on technological innovation, with its most significant holdings being Apple (AAPL), Microsoft (MSFT), Amazon (AMZN), Tesla (TSLA), Alphabet (GOOG) (GOOGL), and Nvidia (NVDA).

After suffering a mini-crash in early-2020 at the onset of the coronavirus pandemic, the QQQ went on to rally by +48% (in 2020) and +27.5% (in 2021). While the acceleration in digital transformation (and secular adoption of technology) was (or is) certainly a major driver of this bullish run, I believe that the one factor that led to the valuation multiple expansion in the QQQ was FED’s quantitative easing program (that flooded the markets with excess liquidity). And as you may know, this liquidity pump is now being unwound.

In November 2021, FED chair – Jerome Powell – announced a u-turn in the central banks’ monetary policy, calling for rate hikes and quantitative tightening (shrinkage of the balance sheet) as inflation caused havoc in the economy. The war in eastern Europe was an unforeseen event that added to inflationary pressures. Even after two rate hikes, inflation numbers are coming in hot; however, the GDP numbers have already turned negative. The fears of stagflation are growing, with the threat of the FED pushing the economy into a recession rising every day now. While the federal funds rate is still below 1%, treasury yields have shot higher in 2022 (amid the worst bond market sell-off in decades), and interest rates are acting like gravity for high-flying technology stocks. Due to its heavy concentration on technology, the QQQ ETF is underperforming other broad-market indices such as S&P 500 (SPY).

As you can see above, the TTM PE ratio for Nasdaq-100 Index has declined from 36x to 25x (as of May 27, 2022) in one year. In my opinion, we are experiencing a valuation re-rating across sectors and asset classes in accordance with the new economic realities – high inflation, low to no economic growth, and rising interest rates (cost of credit).

Is QQQ A Buy During The Dip?

Last week, QQQ surged by 7.12% as the FED minutes called for two more 50 bps rate hikes and then a reassessment (smaller rate hikes or a pause in the tightening cycle). At this news, the stock markets rejoiced, and we experienced a sharp rally. However, I think this rally is nothing more than a long-overdue technical bounce. In the near term, I can see QQQ rallying up to the $320-330 range before turning back lower in the coming months.

While I think we have another +3-8% near-term upside in QQQ from current levels, I see a ~20-25% decline to $250-260 in QQQ over the next six to twelve months. My logic for this medium-term bearishness is based on fundamental, technical, and quantitative analysis. Technically, QQQ is in a falling wedge pattern, and it just broke back into its long-term uptrend channel, which makes a test of the lower end of this channel very likely.

From a fundamental perspective, the Nasdaq-100 still has a PE ratio of ~25-26x (despite the massive correction). The long-term average PE ratio for Nasdaq-100 has been around 15-20x, which means another 20-25% downside from current levels. So far, we have only witnessed a valuation correction, i.e., the price has gone down, and earnings have stayed strong. However, inflation and supply chain disruption is set to hurt corporate earnings, and the risk of an earnings recession is rising. And this is before the FED starting its quantitative tightening program (selling bonds to shrink the balance sheet). Here’s why I believe that the valuation reset in QQQ is not over:

(Note: Apple and Microsoft make up ~25% of QQQ)

The last time 2-Yr Treasury rates were at 2.5%, Apple and Microsoft offered FCF yields of 6% and 3.5%, respectively. Today, Apple offers 3.7%, and Microsoft offers 2.8%. The risk premium here is too low, and if growth were to slow down, the probability of a mean reversion would be very high.

Throughout the 2010s, Apple and Microsoft traded at P/E ratios of 10-30x. Today, both Apple and Microsoft are trading at the high end of this range, and if we were to see a mean reversion to, say, ~15x P/E, we could be looking at ~40-50% downside on both Apple and Microsoft. Now, this is not my base case scenario, and I believe that high-quality businesses like Apple and Microsoft deserve a premium. However, I look at Meta’s P/E of ~15x, and then it is impossible to ignore the downside risk.

In my view, investors are not being compensated fairly for the near to medium-term downside risk in Apple and Microsoft. For the long term, I believe both Apple and Microsoft could deliver double-digit returns to shareholders. However, they may not serve well as safe havens in the medium term. In summary, taking on 40%-50% downside risk in exchange for 10-12% CAGR returns is not attractive to me as an investment.

Source: Apple Vs. Microsoft Vs. Treasury Bonds: The Battle of Safe Havens

I understand that this bear market is painful for investors, but it is what it is, and we are better off not trying to fight the tape. With its largest holdings trading well above their long-term trading multiples, QQQ is at the risk of further correction in the medium term. If you are a long-term investor, I think there are some great opportunities in individual stocks within QQQ like Meta (FB), Alphabet (GOOG), and Amazon (AMZN). Furthermore, high-growth tech has been obliterated over the last twelve months, and there are great deals available in this space.

According to Seeking Alpha’s Quant Rating system, QQQ is a buy at current levels with healthy asset flows, stable dividends, and a low expense ratio. However, the rating for momentum and risk is worsening, and this is something investors need to watch closely over the coming months. I expect these ratings to deteriorate further in the coming months.

Is QQQ A Safe Investment?

I don’t think there’s a good answer to this question because no investment is guaranteed, and the maximum downside for any investment is 100%. Like any other investment, QQQ carries risks. Heavy concentration in the technology sector exposes QQQ to heightened market volatility, and like stocks, QQQ could lead to a possible loss of money. With that being said, QQQ is a diversified basket of stocks, and hence, it is unlikely to blow up by 40-50% in a day (something we have experienced with high growth tech companies like Upstart (UPST) and Teladoc (TDOC) in recent months). Hence, I think of QQQ as a relatively-safe, tech-heavy portfolio.

Concluding Thoughts: Is QQQ Worth Investing In Long-Term?

Personally, I prefer building my portfolios via individual stock picking over index investing, and so this section may be a bit biased. My thought process is pretty simple – “If we want to generate alpha (beat the market) over the long-term, we can’t do so by owning the market (broad-market indices)“. If you look at QQQ’s holdings, it is effectively a basket of the largest non-financial companies in the US. My goal is to beat the QQQ, not track it. From QQQ’s top-10 holdings, I am only buying Meta (FB), Amazon (AMZN), and Alphabet (GOOG) at current levels.

However, if you are a long-term investor looking to avoid the hassle of individual equity research or lack time to build conviction in businesses, owning a diversified ETF may work well for you. Well, my idol, and the greatest investor of all-time – Warren Buffett – recommends index investing for most investors. And I hold nothing against index investing. In my view, QQQ is primarily a basket of high-quality tech stocks. Over the long term, the QQQ could deliver healthy compounded annual returns from these levels. Hence, I think it is a decent investment for the long haul.

In the near term, I see QQQ running up to the $320-330 range, but over the medium term, we are likely to decline to $250-260. These targets are based on fundamental, quantitative, and technical analysis shared in today’s note. With a near-term upside of 3-8% and a medium-term downside of ~20-25%, I’m not too fond of QQQ’s risk/reward here. Therefore, I am neutral on QQQ at current levels. With that being said, I see fantastic buying opportunities in individual names within the technology sector. Being selective and patient is key in a bear market. Happy investing!

Key Takeaway: I am neutral on QQQ at current levels.

Thank you for reading. Please feel free to share any questions, thoughts, or concerns in the comments section below.