A lot has changed since my last update on the benchmark Nasdaq 100 ETF, Invesco QQQ Trust (NASDAQ:QQQ) in early September. The ETF, which is the largest and most liquid ETF tracking the Nasdaq 100, dropped 10% to its October lows amid fears of higher for longer interest rates, before weakening macro and inflation data triggered a major three-week rally, bringing the QQQ back to its July 7 highs. Bulls are looking for a repeat of 2019 when a mild economic slowdown allowed monetary easing to drive the QQQ higher. However, I see three reasons why this is unlikely.

1: Rate Cuts Will Likely Require Equity Market Weakness

The slight miss in US October CPI has increased expectations of rate cuts in 2024, with markets now pricing in 100bps of cuts between now and December next year. I have no particular view on that, but the problem for the QQQ is that over the past 25 years, the Fed has never cut rates until after a spike in credit stress, which has tended to also undermine stocks. This can be seen in the chart below which shows US high-yield credit spreads against the Fed funds rate.

Even the slight easing that occurred in H2 2019 was preceded 8 months earlier by a 230bps spike in credit spreads and a 20% fall in the QQQ, and CPI was running below 2% at the time. This is the reason why rate cuts are often bullish for stocks, as they happen only after stocks have already declined and are often cheap and oversold. This is not the case today.

2: Valuations Are More Expensive And The Growth Outlook Weaker

This brings me to the second point which is that the H2 2019 rally that followed the beginning of monetary easing began when the PE ratio on the QQQ was around 23x compared to over 30x today. Furthermore, total Nasdaq 100 earnings were 27% of the S&P 500 back then compared to 35% now.

For the longest time, US investors have applied a discount to the largest stocks in the market. For almost a full decade prior to COVID-19, the median S&P 500 stock traded at a higher PE ratio than the overall index. Furthermore, the NDX traded at a large discount to small-cap stocks throughout this period.

The reason for this discount is that larger companies have tended to experience slower long-term growth, which has outweighed the positive impact of factors such as stable earnings and strong balance sheets. Growth is a function of market penetration and economic growth, and with NDX 100 earnings now at 35% of the whole US market, up from 20% a decade ago, earnings growth should converge to the rate of nominal GDP growth.

NDX earnings have outpaced nominal GDP growth by around 8% over the past decade, with sales growing 5% faster and rising margins accounting for the rest of the outperformance. If this were to continue for another decade NDX earnings would rise to around 75% of the overall market from 35% currently, assuming SPX earnings keep pace with GDP growth. This is unrealistic and so a slowdown in growth relative to the economy and the S&P 500 is inevitable.

Even if we assume that current near-record margins remain intact and sales growth continues to outperform the economy by 5%, this is likely to result in less than 10% annual returns assuming 4% trend GDP growth, with the dividend yield adding less than 1%. This would put the QQQ near fair value as stocks have typically outperformed bonds by around 5% annually.

If NDX earnings growth were to slow to the pace of the overall economy over the next decade as I expect, this would put QQQ returns in line with bonds. This may sound fine, but if investors are anticipating perpetual 5% earnings growth outperformance and 10% total returns, then a major decline in valuations could result. If investors were to implicitly require QQQ to return 10% annually amid 4% earnings growth and a 0.8% dividend yield, this would require an 88% decline in valuations. Such is the sensitivity of expensive stocks to growth assumptions.

3: Tech Stocks Are Already Universally Loved

It appears that a melt up in the QQQ would surprise very few investors. Not one Wall Street analyst has a sell recommendation on Google (GOOG) (GOOGL), Amazon (AMZN), Nvidia (NVDA), or Microsoft (MSFT), and the percentage buy rating ranges from 85% in the case of Google to 97% in the case of Amazon. Meanwhile, hedge funds are fully loaded up on Mega Cap tech, with net exposure running in the 99% percentile since 2010.

I remember back in 2013 when hedge fund exposure was below 4% on the chart above. Despite deeply negative real interest rates at the time the forward PE ratio was just 13x, with the dominant narrative that slow growth prospects justified these valuations. The current euphoria surrounding Mega Cap stocks, while not a timing indicator, is cause for caution at the very least.

Goldilocks And 1990s Redux Are Two Main Risks

The main risk to my bearish view on the QQQ is that growth and inflation data continue to weaken sufficiently to allow rate cuts but not enough to cause a significant decline in earnings expectations. However, leading economic indicators show we are far from out of the woods regarding a H1 2024 recession, while the budget deficit is likely to keep inflation elevated absent any spike in credit risk.

Another risk is that we see the NDX following the path it took in late-1999 when it turned parabolic from already extremely overvalued levels. However, it is hard to see what kind of narrative could justify such a move as the macro outlook contrasts greatly with that period.