The NASDAQ 100 ETF (NASDAQ: QQQ) has seen an explosive rally in short hedges in recent weeks as funds reduce risk from their portfolios. It has pushed the QQQ ETF up nearly 23% from the June 16 lows. These types of gatherings within secularism bear markets are not that rare; similar or larger rallies occurred in the 2000 and 2008 cycles.
To make matters worse, the NASDAQ 100’s PE ratio has rallied to levels that put this index back in expensive territory on a historical basis. That ratio has fallen back to 24.9 times 2022 earnings estimates, pushing the ratio 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 down, falling about 4.5% from their peak of $570.70 to around $545.08 per share. Meanwhile, the same estimates are up just 3.8% from this time a year ago. This means that paying nearly 25 times earnings estimates is not a good deal.
Real yields soared, making the NASDAQ 100 even more expensive relative to bonds. The 10-year TIP is now trading around 35 basis points, down from -1.1% in August 2021. Meanwhile, the NASDAQ earnings yield has risen to around 4%, meaning the spread between actual yields and the NASDAQ 100 earnings yield narrowed to just 3.65%. This gap between the NASDAQ 100 and the actual yield has narrowed to its lowest point since the fall of 2018.
Financial conditions have eased
The reason the spread is narrowing is because financial conditions are easing. Easing financial conditions appear to be leading to a narrowing of the spread between equities and real returns; when financial conditions tighten, the gap widens.
If financial conditions ease further, there may be a new multiple expansion. 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 up in Fed Fund futures, which remove the dovish pivot. Rates have increased dramatically, especially in the months and years after 2022.
But more importantly, for this monetary policy to effectively feed through to the economy, the Fed needs financial conditions to tighten and be a restraining force, which means the Chicago Fed National Financial Conditions Index must go above zero. As financial conditions begin to tighten, this should cause the spread to widen further, leading to further multiple compression in the value of the NASDAQ 100 and lower QQQ. This could cause the NASDAQ 100 PE ratio to drop to around 20. With earnings this year estimated at $570.70, the value of the NASDAQ 100 would be 11,414, a drop of almost 16%, sending the QQQ back to a range of $275. at $280.
No unusual activity
Moreover, what we see in the market is nothing new or unusual. This has happened in the two most recent bear markets. The QQQ rose 41% from its intraday lows of May 24, 2000 to July 17, 2000. Then, a few weeks later, it did it again, rising 24.25% from its intraday lows of August 3, 2000 to September 1, 2000. What followed was a massive sell-off.
The same thing happened from March 17, 2008 to June 5, 2008, with the index increasing by 23.3%. The thing is, these sudden, abrupt gatherings are not unusual.
This rally took the index and ETF back to an overvalued position and retraced some of the more recent declines. It has also put renewed emphasis on financial conditions, which will need to tighten further to begin to have the desired effect of slowing the economy and reducing the rate of inflation.
The recovery, while pleasant, is not expected to last as the Fed’s monetary policy will need to be tighter to effectively bring the inflation rate back to the Fed’s 2% target, which will result in significant deviations , lower multiples and slower growth. All bad news for stocks.