Market outlook

Invesco QQQ fall update

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Introduction

2022 has been a challenging year for Invesco QQQ ETF (QQQ), the Nasdaq-100 Index (index that QQQ tracks) and markets overall. We spend the next pages discussing some of the drivers of performance periods that we have seen through the year, give some historical context on valuations as well as frame our thoughts for the near term and medium/longer term for QQQ. We expect volatility to persist for the remainder of the year as inflation continues to run above the Federal Reserve’s (Fed) long term target and tighter monetary policy measures are enacted in an effort to restore price stability. Over the medium to longer-term, we believe that the thesis behind QQQ and the Nasdaq-100 is the companies’ ability to drive fundamental growth. Companies within the Nasdaq-100 have been adept at identifying change and capitalizing on changing dynamics in the market. We believe these companies dedication to innovation, fueled by a commitment to Research & Development, has allowed these companies to branch out into new markets and uncover new opportunities.

Three distinct performance periods

12/31/2022 – 06/16/2022: Valuation Selloff

During this period, QQQ NAV fell by 31.60%. Sentiment deteriorated in the first half of 2022 as several risks converged, including rising inflation, the beginning of tighter monetary policy following the Federal Reserve’s “liftoff” (the first rate increase off of their target rate of 0%- 0.25%), geopolitical issues and continued supply chain pressures. There was an aversion to growth in the market, and growth-oriented companies and sectors categorized by higher valuations came under particular pressure. These pressures were fueled by rampant inflation with year-over-year Consumer Price Index (CPI) climbing above 8% and eventually 9% in June, the highest levels since November 1981. 1 Amid the higher inflation figures, there was much speculation around the Fed’s projected course of action to control hot inflation. The Russian invasion of Ukraine negatively impacted market sentiment and sent commodity prices higher adding additional upward inflationary pressure, while China’s zero-tolerance COVID policy put added strain on already fragile supply chains. Headlines were largely negative for the first half of the year and sent markets broadly lower. Ultimately amid these risk factors, we saw trailing 12-month price-to-earnings ratio on the Nasdaq-100 index fall from 37.47 on December 31, 2021, to 23.32 on June 16, 2022.

Standardized Performance. Performance data quoted represents past performance, which is not a guarantee of future results. An investor cannot invest directly in an index. Index returns do not represent Fund returns.

06/16/2022 – 08/15/2022: Summer rally

Halfway through June, there seemed to be a change in market sentiment, and a rally through mid-August took hold.  The “valuation selloff” of the first six months of the year, left the Nasdaq-100 index trading at discounts to 20-year averages of both trailing 12-month price to earnings ratio and forward price to earnings ratio (Source: Bloomberg L.P., as of 06/15/2022), and represented the least expensive trailing 12-month price to earnings ratio and forward price to earnings ratio since the Spring of 2020.2 Accessing this basket of companies at these discounted valuation levels was further aided by a round of earnings reports that were “not as bad” as feared. Through September 2nd, 93 of the companies within QQQ had reported earnings for Q2 and 59% surprised earnings estimates to the upside, 29% of companies had no surprise and only 12% had a negative surprise. This compares with Q1 where 56% of companies had reported a positive earnings surprise. QQQ NAV rallied by 22.91% during this period.

8/15/2022 – Today: Delay of the dovish Fed’s return

This period could be described as the delay of the dovish Fed’s return. Following the round of “less bad” earnings reports, attention turned squarely to inflation and the Fed.  Jerome Powell’s speech at the Economic Symposium in Jackson Hole hosted by the Kansas City Fed, acknowledged that households and businesses will feel pain as the Fed continues its fight against inflation. Chairman Powell noted the importance of regaining price stability, and that the Fed cannot afford to pivot in its fight against inflation. Consequently, the speech took a rather hawkish tone. Forecasts for the rate hike at the Fed’s September meeting increased from the week before the speech to the week after, as more market participants expected the Fed to raise rates by another 75 basis points.3 As of September 1st, many investors are anticipating the Fed will raise rates to higher levels in 2023 before embarking on an accommodative rate cut. Based on the Fed Funds Futures on September 1st, market participants are barely beginning to price in a rate cut for May 2023 after reaching an implied Fed funds rate of 3.953%.4 Additionally, in September, the Federal Reserve is doubling the pace of its balance sheet reduction, to $95 billion per month ($60 billion of Treasuries and $35 billion of Mortgage-Backed Securities).

The risks that market participants were focused on in the first half of the year have returned. With inflation remaining above the Fed’s target rate of 2%, how much will the Fed’s restrictive monetary policy hamper economic growth, as Chairman Powell warned of pain to households and businesses. Impacts to economic growth have been seen throughout 2022, as the last two quarters have shown gross domestic product (GDP) contraction. Q1 GDP was reported at a 1.6% contraction and thus far Q2 readings have shown a 0.6% contraction in economic growth.

With these risks, we have seen volatility gauges on both the Nasdaq-100 index (as measured by VOLQ index) and the S&P 500 index (as measured by the VIX index) climb from their four-month lows in August.5,6

VOLQ Index and VIX Index 03/01/2022 - 09/01/2022

Source: Bloomberg, L.P., as of 9/1/2022

We believe this environment of elevated volatility is likely to persist for the remainder of the year as investors will be keenly aware of major events such as economic releases pertaining to inflation, policy decisions from the Fed and results or commentary from companies regarding impacts to their businesses in the current market environment.

Despite some of the near-term risks in sentiment, there are areas for potential optimism as we look ahead over the medium to long-term. 

Earnings

One bright spot has been the earnings resiliency of the Nasdaq-100. 2021 calendar year earnings growth of 27.49% for the Nasdaq-100 index represented the strongest full-year earnings growth for the Nasdaq-100 index since 2011’s 31.59 % growth (from 2010). 

Nasdaq-100 Earnings Growth

Year  Year-Over-Year Earnings Growth
2011 31.59%
2012 2.49%
2013 2.58%
2014 16.44%
2015 5.61%
2016 6.51%
2017 21.85%
2018 21.09%
2019 3.30%
2020 5.02%
2021 27.49%

Source: Bloomberg L.P, as of 9/6/2022

The risk that earnings estimates may continue to come down exists, as analysts scrutinize specific earnings results and commentary from companies around impacts from inflation and pressure from slowing economic growth. Even with this risk, there is a fair amount of leeway that estimates could decline while still showing earnings growth for the index. 

Valuation

Valuation post COVID seemed to be one of the largest areas of pushback for sentiment around QQQ. The companies within the Nasdaq-100 index experienced valuation multiple expansion—when an asset is purchased and later sold at a higher valuation multiple relative to the original multiple paid—as investors bid up many of the technologically oriented companies that were imperative to maintain connectivity throughout lockdowns, quarantine, and work from home. At various points, the index was trading at a trailing 12-month price to earnings ratio over 40, the highest levels since 2004. Because of the performance slide so far this year, we have seen valuations retreat to much more reasonable levels, and closer to their long-term averages. 

Nasdaq-100 Current Valuations, 10-year and 15-year Average Valuations

  09/01/2022 10-year average (09/12 – 09/22) Premium/ Discount 15-year average (09/07 - 09/22) Premium/ Discount
TTM P/E Ratio 25.16 25.39 -0.91% 23.98 4.92%
FTM P/E Ratio 22.76 21.59 6.67% 20.15 12.95%

Source: Bloomberg L.P, as of 9/2/2022

Nasdaq-100 Current Valuations vs. Historic Valuations

    Current                    5 years ago (09/17) Premium/ Discount 10 years ago (09/12) Premium/ Discount 15 years ago (09/07) Premium/ Discount
TTM P/E Ratio 25.16 25.30 -3.93% 17.04 47.65% 30.64 -17.89%
FTM P/E Ratio 22.76 21.94 3.74% 14.78 53.99% 26.14 -12.93%

Source: Bloomberg L.P, as of 9/2/2022

As shown in the table above, Nasdaq-100 valuations are trading in-line with levels during the same period 2017, at a premium to the same period in 2012 and at a discount to the same period in 2007. Clearly the valuation premium relative to 2012 stands out in the above table. It is important to make several observations about that period. The years 2011 and 2012 represented explosive growth for the Nasdaq-100 index following the Great Financial Crisis in 2008-2009. Year-over-year earnings grew 55.21% in 2010 (from 2009) and 31.59% in 2011 (from 2010). From a forward P/E ratio standpoint, 2011 represented the valuation lowest level in the 15-year observed period, while trailing 12-month P/E was the lowest level outside of the Great Financial Crisis in the 15-year observed period. Ultimately, Nasdaq-100 valuation levels have retreated to levels near their historical averages, and off the historical high levels we saw amid the COVID market environment.

Nasdaq-100 P/E Ratio and Fwd P/E Ratio 09/01/2007 - 09/01/2022

Source: Bloomberg, L.P., as of 9/1/2022

Long-Term Drivers of Earnings Growth

As we look into the medium- and longer-term outlook, it hinges on growth. What will be the driver of earnings growth in the next 3 years, 5 year or even decade? We believe the exposure to various disruptive technologies that companies within QQQ have carved out helps to frame that story. In the graph below, you will see patent contributions of Nasdaq-100 companies across 35 different disruptive technologies from May 31, 2021 – May 31, 2022. 

Patent Contribution of Nasdaq-100 Companies to Selected Disruptive Technologies (trailing 1-year as of 5/31/2022)

Source: Yewno, Nasdaq as of 6/30/2022

For instance, Nasdaq-100 companies filed 35.1% of all patents relating to Cloud Computing in the observed timeframe.

These disruptive technologies are well diversified across both the underlying businesses as well as the time horizon for some of these to develop. Themes like Cloud Computing, Wearable Technology, and Big Data are already a growing part of our daily lives, and companies’ bottom lines.  Others like Bioinformatics, Virtual Reality, Nanorobotics and Quantum Information and Optics are still in the relatively early stages of development but may one day become an indispensable part of how we function as a society, and as such, a significant contributor to companies’ bottom lines. 

Conclusions

We expect the volatile environment that we have observed since mid-August to likely persist as investor attention remains firmly fixed on inflation and the Fed’s response to regaining price stability. Press conferences from the Fed and Chairman Powell’s (along with other Fed Governors’) commentary will likely be scrutinized, as market participants try to glean insight on the Fed’s future decisions on monetary policy. This has the potential to bring added headline risk into the market.

The longer-term thesis for QQQ remains intact. The strategy gives exposure to the Nasdaq-100 index, comprised of some of the most innovative companies in the world and we believe these companies’ success has been driven by real fundamental growth. Over the past 15 years, from Q2 2007 through Q2 2022 on a trailing 12-month basis, Nasdaq-100 earnings grew by over 650%, which we believe has been fueled by a long-term commitment to research & development. These companies have fostered a culture of innovation, which underscore the ability to stay nimble in how their businesses adapt to changing trends in the market and society. At present, these companies have exposure to a number of different disruptive technological themes, and this varied exposure can serve as a diversification tool in companies’ quest to find the next big contributor to bottom-line growth. 

Footnotes

  • 1

    The Consumer Price Index (CPI) measures the average change in prices over time that consumers pay for goods and services.

  • 2

    Price to earnings ratio (P/E ratio) conveys how much investors will pay per share for $1 of earnings. The P/E ratio is simply the stock price divided by the company’s earnings per share for a designated time period.

  • 3

    One basis point is equal to 1/100th of 1% and is used to denote the percentage change in a financial instrument.

  • 4

    Fed funds futures are derivatives based on the federal funds rate, the U.S. overnight interbank lending rate on reserves deposited with the Fed.

  • 5

    The Nasdaq-100 Volatility Index (VOLQ) is a measure of implied volatility on the Nasdaq-100 Index.

  • 6

    The CBOE Volatility Index (VIX) is a measure of implied volatility on the S&P 500 Index.

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