VOO Vs. QQQ: Bubble Signs According To Ray Dalio (NASDAQ:QQQ)

Thesis

In his e book entitled “Ideas For Navigating Huge Debt Crises”, Ray Dalio developed a framework to establish market bubbles. As seen within the chart under, the gist of the framework is a seven-point guidelines. These indicators embody excessive costs relative to conventional measures, numerous new consumers coming into the market, broadly bullish sentiment, et al.

The thesis of this text is to argue that the present market reveals a number of of the above indicators. I really assume the market is exhibiting all 7 indicators presently. Moreover, I’ll argue that the bubble indicators are extra extreme within the tech sector, and fewer extreme in different sectors (reminiscent of worth or small cap).

Nonetheless, on this article, I’ll look at two indicators particularly: the primary one (excessive costs) and the fifth one (new market participant) for 2 causes. First, I need to restrict the article to an inexpensive size. And secondly and extra importantly, different points reminiscent of tightening dangers and the usage of leverage at a macroscopic scale have been a frequent matter on SA. Thus, right here I need to look at these two points which can be much less typically mentioned.

Within the the rest of this text, I’ll use the Vanguard S&P 500 ETF (NYSEARCA:VOO) to approximate the “total market” represented by the S&P 500 index. And I’ll use the Invesco QQQ Belief ETF (NASDAQ:QQQ) to approximate the tech sector. As defined in my earlier article, the benefits to make use of a mature ETF as an alternative of the market indices themselves are:

• It’s a lot simpler for me to drag ETF knowledge than market indices knowledge. And I assume it’s the similar for the readers too (in case some readers need to confirm or lengthen my analyses).
• Historic knowledge has proven that giant mature ETFs reminiscent of QQQ and VOO monitor the underlying index intently, and as such, the error concerned on this approximation is negligible.
• And at last, as a aspect profit, by anchoring the dialogue with a selected ETF, the dialogue generally is a bit extra concrete and actionable. In any case, many extra traders specific their view on the “market” through particular ETFs relatively than buying and selling the index itself.

VOO vs QQQ: fundamental data

Each VOO and QQQ are giant funds with a protracted historical past (and subsequently providing loads of historic knowledge) in their very own area. QQQ was launched in 1999. It tracks the tech-oriented NASDAQ 100 index and is subsequently thought of a large-growth fund as seen within the chart under. As one of many largest funds within the tech area, it boasts greater than $190B of AUM and is ranked the second most traded ETF within the US as of Mar 31, 2023 (based mostly on its common every day quantity traded). Equally, VOO is without doubt one of the largest EFTS monitoring the S&P 500. It has a good bigger AUM of over $300B. Notice that VOO incorporates a a lot decrease expense ratio of 0.03% in comparison with QQQ’s 0.2%.

Bubble signal 1: excessive costs

With the above data, let’s dive in and look at the bubble indicators in depth. And let’s begin with excessive costs. As seen within the chart under, VOO has traditionally traded with a P/E ratio within the vary of 17.2x to twenty-eight.9x (10y Vary) and its present P/E ratio stands at 24.79x. Its present P/E ratio is about 23% above its 10y Median of 20.2x.

It’s troublesome to completely visualize the importance of a 23% premium till we put it in a broader context (see the second chart). Its present valuation is among the many highest degree prior to now 140+ years. Fortune revealed a report in July 2021 to argue that the “S&P 500 has solely been this costly for 4% of the previous 140 years”. On the time of that article, the S&P 500 was buying and selling at 26.5x P/E. The present P/E is just about 6% decrease than that. Plus, you’ve got to remember that the present risk-free rates of interest are a lot larger than these in July 2021. Consequently, benchmarked towards risk-free rates of interest, the present valuation is nearer (and even larger as argued on this article) to the July 2021 degree than on the floor.

The image for QQQ is much more regarding. As seen within the first chart under, QQQ has traditionally traded with a P/E ratio within the vary of 19.7x to 36.2x (10y Vary) and its present P/E ratio stands at 35.8x, which is inside 1% of its 10-year peak valuation. Its present P/E ratio is about 48% above its 10y Median of 24.2x. In QQQ’s case, there isn’t a 100-year historic P/E knowledge that I can discover. So, I’ll contextualize its present valuation premium otherwise (which is alongside the road of the second merchandise on Dalio’s guidelines). Assuming a beneficiant 6%~8% growth charge for the final economic system, a 48% premium would A) both take 6 to eight years of development to catch up or B) requires the tech sector to outgrowth the final economic system by a big margin. Even when the tech sector grows at 12% a 12 months (i.e., about doubling the general economic system), a 48% premium would nonetheless take 4 years of development to catch up.

Bubble signal 2: new individuals

Now, onto the two^nd warning signal. A big quantity, really it’s not an exaggeration to say {that a} file quantity as proven within the subsequent chart under, of recent consumers have entered the market prior to now 1 12 months or so. That is thought of a effervescent signal (not solely by Dalio solely BTW) for good causes. It suggests that there’s a lot of demand for shares, and consumers are prepared to pay costs far above (as argued above) their honest worth. In line with Vanda Analysis, retail traders have spent a file $1.51 billion a day within the US markets throughout the month of February 2023.

Particular to QQQ and VOO, the image may be very related as proven within the two charts under. Really, given the size and recognition of those two funds within the respective area, I’d count on the influx of recent funds into these two ETFs to be far above common. To wit, the primary chart under reveals that VOO’s fund move is totally dominated by influx prior to now 12 months. The fund solely had 5 weeks of outflow prior to now 12 months, and its web move totaled a whopping $31.2B. In different phrases, its web influx prior to now 1 12 months is greater than 10% of its present AUM. As a extra actively traded EFT, QQQ’s fund move fluctuated extra as proven within the second chart under. Nonetheless, total, the fund additionally attracted a large web influx prior to now 12 months, totaling $4.75B.

Dangers and different concepts

To recap, I’m seeing many (if not all) of the 7 warning indicators that Ray Dalio developed to establish market bubbles. I targeting two of the 7 warning indicators: excessive valuations and new market individuals. I additionally touched on the chance that the present valuation a number of (particularly within the case of QQQ) implied speedy future development far outpacing historic financial development charges. Different dangers embody the final use of excessive leverage after the epic QE throughout the COVID, the tightening dangers forward on account of persisting inflation, and in addition the focus dangers (once more, particularly within the case of QQQ). The return within the total market this 12 months is dominated by a number of firms, that are perceived to profit from the AI increase. To wit, my analyses present {that a} complete of solely 6 firms (Microsoft, Google, Amazon, Meta, Nvidia, and Salesforce) have contributed to about 50% of VOO’s return YTD and virtually 55% of QQQ’s development of 54%.

By this time, when you see the indicators of the bubble as I see them, then the subsequent logical query is what are the alternate options concepts? The valuation dangers are erratically distributed. My view is QQQ (or different equal tech funds) have larger dangers, VOO’s dangers (or different equal large-cap mix funds) are comparatively decrease, and worth and small caps have even decrease danger premiums. Specifically, the valuation hole between QQQ (i.e., the Nasdaq 100 Index) and small caps (i.e., the Russell 2000 Index) shouldn’t be on the highest level – the identical degree as that earlier than the burst of the dot-com bubble in 2000 in response to the next Blomberg knowledge.

Consequently, traders may take into account changing VOO with a complete market fund such because the Vanguard Complete Inventory Market Index Fund ETF (VTI). As you’ll be able to see from the subsequent chart under, VTI is a fund that we really maintain as a part of our core portfolio as an alternative of VOO or QQQ. In comparison with VOO or QQQ, VTI supplies publicity to mid-cap and small-cap for higher diversification and in addition hedges towards the valuation dangers concentrated within the large-cap area. Buyers who’ve extra dangers tolerated may take into account a concentrated publicity to small-cap funds reminiscent of iShares Core S&P Small-Cap ETF (IJR) or iShares Russell 2000 ETF (IWM) to wager on the above record-level valuation hole.

Lastly, for publicity to the tech area, area of interest sectors such because the SPDR S&P Biotech ETF (XBI) are additionally attractively valued in our view (and in addition present focus publicity to the small caps on the similar time). And our substitute for QQQ may appear a bit counterintuitive on the floor. As seen within the chart under, we use the ProShares UltraPro QQQ (TQQQ), a leveraged QQQ fund to achieve publicity, which appears to extend our leverage to QQQ on the floor. Nonetheless, by controlling its goal allocation (presently 8.6% as seen), we even have decrease publicity in absolute greenback quantity. Additionally, following a disciplined method (detailed in my earlier article), an optimum steadiness could possibly be obtained between the volatility decay and volatility increase related to leveraged funds to supply alpha. All instructed, with these different concepts, our portfolio has been main the general market by a small margin (to date).