The NASDAQ 100 ETF (NASDAQ:QQQ) has seen an explosive rally in short hedging in recent weeks as funds de-risk their portfolios. It has boosted the QQQ ETF nearly 23% since the June 16 low. These kind of lay inside rallies bear markets are not that rare; During the cycles of 2000 and 2008 there have been rallies of similar size or of greater importance.
To make matters worse, the PE ratio of the NASDAQ 100 has spiked back to levels that put this index back in expensive territory on a historical basis. That ratio returns to 24.9 times earnings estimates for 2022, bringing the ratio back to one standard deviation above its historical average since mid-2009 and the 20.2 average.
On top of that, earnings estimates for the NASDAQ 100 are on the decline, falling about 4.5% from its high of $570.70 to around $545.08 per share. Meanwhile, the same estimates are up just 3.8% from this point a year ago. It means that paying almost 25 times earnings estimates is not a bargain.
Real yields have soared, making the NASDAQ 100 even more expensive compared to bonds. The 10-year TIP is now trading around 35bps, up from -1.1% in August 2021. Meanwhile, the NASDAQ earnings yield has risen to around 4%, meaning the spread between the real returns and earnings yield of the NASDAQ 100 has dropped to just 3.65%. That spread between the NASDAQ 100 and actual performance has narrowed to its lowest point since the fall of 2018.
Financial conditions have eased
The reason the spread is contracting is that financial conditions are loosening. As financial conditions ease, the spread between equities and real yields appears to be narrowing; when financial conditions tighten, it causes the spread to widen.
If financial conditions ease further, there may be more multiple easing. However, the Fed wants inflation rates to come down and is working hard to reshape the yield curve, and that work has started to show in Fed Fund futures, which are removing the dovish pivot. Rates have increased dramatically, especially in the months and years after 2022.
But more importantly, for this monetary policy to spread effectively through the economy, the Fed needs financial conditions to tighten and be a restrictive force, which means that the Chicago Fed’s national index of financial conditions must move above zero. As financial conditions start to tighten, it should result in the spread widening again, leading to further multiple compression of the NASDAQ 100 value and causing QQQ to decline. This could result in the PE ratio of the NASDAQ 100 falling back to around 20. With earnings this year estimated at $570.70, the value of the NASDAQ 100 would be 11,414, a decline of almost 16%, which would send the QQQ again to a range of $275. to $280.
not unusual activity
Furthermore, what we see on the market is nothing new or unusual. It happened during the two most recent bear markets. QQQ rose 41% from its intraday lows of May 24, 2000 to July 17, 2000. Then a couple of weeks later, it did it again, rising 24.25% from its intraday lows of August 3 2000, until September 1, 2000. What followed was a massive sale.
The same thing happened from March 17, 2008 to June 5, 2008, with an index increase of 23.3%. The point is that these sudden and sharp spikes are not unusual.
This rally has pushed the index and ETF into an overvalued position and retraced some of the more recent declines. It also put the focus back on financial conditions, which will need to tighten further to start having the desired effect of slowing down the economy and reducing the rate of inflation.
The rally, while nice, is not likely to last as the Fed’s monetary policy will need to tighten to bring the rate of inflation back to the Fed’s 2% target, and that will mean wide spreads, lower multiples and slower growth. All bad news for stocks.