Since my last article on the Nasdaq 100 ETF, Invesco QQQ Trust (NASDAQ:QQQ) in mid-November, the market has risen 10% to new all-time highs. Since the start of 2024 it has completely decoupled from bond yields, which had previously been seen as a major driver of tech stocks. The bearish thesis that I argued in November remains valid; Fed rate cut expectations remain too aggressive, valuations are extreme, and sentiment and positioning in mega cap tech remains a contrarian risk.
However, the most important factor in the short term is the market trend and the QQQ has burst to new all-time highs and this has also been confirmed by a new closing high on the S&P 500. The risk is that we see the QQQ turn parabolic over the coming months as was the case in late-1999 when tech stocks went on to almost double over the next few months from already-extreme levels. For short term focused investors, QQQ call options offer a cheap way to benefit from a melt up, while for long term investors the index is best avoided as a combination of extreme valuations and slowing growth imply extremely poor 10-year returns.
Call Options Offer A Cheap Melt-Up Hedge
The QQQ closed last week on a very strong note, closing at a new all-time high after consolidating above its 2021 highs. The Magnificent 7 stocks continue to lead the market higher and we have also seen an increase in participation, with index of the other 93 stocks in the Nasdaq 100 also hitting new all-time highs, along with the S&P 500.
With this in mind, I am no longer short the QQQ and will wait for signs of weakening price action before re-entering shorts. A close back below $400 on the QQQ, which corresponds to around $16,600 on the Nasdaq 100 would provide such an opportunity as it would suggest a false bullish break, setting the stage for a potential downside reversal.
When compared to the late-1990s period, implied volatility is extremely depressed. While I do not have data for the QQQ or the Nasdaq 100, implied volatility on the S&P 500 in the late-1990s was around double current levels. One way to take advantage of this low implied volatility is to buy calls and puts. A 1-month 5% out of the money call on the QQQ currently costs just 0.3%, while a 3-month 10% otm call costs around 0.5%. For a nominal fee call buyers can gain exposure to a potential 1999-style melt up.
Bearish investors could also combine a short position on the QQQ, which generates positive cash flow as they receive interest far in excess of dividend payments, with a long call position to hedge against a surge higher while also maintaining exposure to a downside reversal.
Long Term Investors Should Use Strength To Take Profit
From a long term perspective, it must be reiterated how poor returns are likely to be given current valuations and growth prospects. Even after the recent recovery in margins, the Nasdaq 100 free cash flow yield is just 2.8%, meaning that the market is relying on continued rapid growth to drive returns. However, Nasdaq 100 free cash flows are now 40% of the entire US market and almost 20% of the entire US economy's profits. It is almost inevitable due to the law of large numbers that Nasdaq profit growth will slow to the pace of the overall economy over the long term.
It may surprise some to know that Apple's (AAPL) free cash flows have actually underperformed the S&P 500 and nominal GDP since 2015 as the company has gotten so large that growth has inevitably suffered. This is the fate that awaits the entire Nasdaq 100 and is likely to result in sales and profit growth falling in line with nominal GDP. In real terms, GDP growth is likely to trend down towards 1% over the coming years, based on the decline in productivity. Even if companies are able to return all their free cash flows to shareholders via dividends and buybacks, investors should expect no more than 4% real annual total returns over the long term. This is roughly the same annual real return figure as has resulted from the 2000 QQQ peak, but over this time the ETF experienced an 84% real decline. A similarly large market crash should not be overlooked this time around, despite the current bullish trend.
Summary
My bearish fundamental view on the QQQ remains valid but the risks of a late-1990s style melt up have risen thanks to the recent rally to all-time highs, which has been confirmed by the broader market. Low implied volatility suggests that out of the money call options offer a cheap hedge against a spike higher, while extreme valuations and weak growth prospects suggests long term focused investors should use any strength to take profits.
Stuart Allsopp
I am a full-time investor and owner of Icon Economics - a macro research company focussed on providing contrarian investment ideas across FX, Equities, and Fixed Income based on Austrian economic theory. Formerly Head of Financial Markets at Fitch Solutions, I have 15 years of experience investing and analysing Asian and Global markets.
Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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