TQQQ ETF: I Still Recommend Caution Ahead Of Q4

Main Thesis/Background

The purpose of this article is to evaluate the ProShares UltraPro QQQ ETF (NASDAQ:TQQQ) as an investment option as its current market price. This is a leveraged fund with an objective to seek “daily investment results, before fees and expenses, that correspond to three times (3x) the daily performance of the Nasdaq-100 Index”.

This is a fund that – due to its strategy – should be approached cautiously in most environments. There are times, especially in the short-term, when using leveraged ETF looks too good to pass up. But three months ago I didn’t see that environment. Although I took some flack for that in the comments section of my article on TQQQ roughly three months ago, overall performance actually shows that my “hold” rating was indeed appropriate over time:

Given the ups and downs TQQQ has seen over the past quarter, I thought it was time to take another look at the forward outlook to see if I should change my rating. While I remain modestly bullish on large-cap US stocks, I think the risk-reward backdrop is a challenging one. This tells me that laying on extra risk – whether through 3X leveraged funds or through other methods – is perhaps not the best play at the moment. For this reason I am maintaining my “hold” rating and will detail the reasons why below.

A Reminder On TQQQ’s Strategy

I will begin with a reminder on how TQQQ operates. As a 3X leveraged fund, this is a holding with a high level of inherent risk. So investors should approach this selectively in any circumstance regardless of what is going on in the market. Keeping a focus on each individual’s unique risk tolerance and ability to withstand what can be large losses is important.

How TQQQ works it is gives investors exposure to the underlying NASDAQ 100 index and generally will move in correlation as the Invesco QQQ Trust ETF (QQQ) (but at 3 times the rate). To do this, TQQQ owns stocks, but also derivatives. These “swaps”, as well as other debt products, amplify the returns (and losses) for TQQQ compared to QQQ:

This has a few implications. One, TQQQ’s use of debt and swaps amplifies the potential gains, but also risks and expenses. This is why TQQQ has an expense ratio near 1% (high for an ETF). As a result, investors are taking on quite a bit of risk but also are paying a high fee to hold this exposure. Thus, readers should be prepared to enter this trade on a short-term basis only, in my view. Expenses will eat away at returns over time and the potential for large losses means this isn’t best “buy and hold” approach. Could one be successful doing that? Yes. But it is not something I would recommend for the average person.

Note: Most leveraged ETFs (such as TQQQ) are only designed to accomplish the stated leveraged objective on a daily basis. These funds are clear in their acknowledgment that returns may lag their stated objective over a longer period. Returns can differ significantly from the performance (or inverse of the performance) of their underlying index or benchmark over the same period of time, which can make these products risky long-term-or even medium-term-investments, especially in volatile markets. For more information, please consult guidance from FINRA here.

NASDAQ 100’s Relationship With Treasury Yields Have Changed

One interesting item to monitor for the remainder of 2023 has been the breakdown in the relationship between treasury yields and Tech share prices. What I mean is – this is typically a sector that performs very well in a low interest rate environment (which I am sure readers know quite well!). Then, in 2022, as treasury yields shot up, Tech took a beating. While the losses last year may have been a bit overblown, what may have taken some investors by surprise is the sharp rebound in large-cap Tech shares in 2023 – despite treasury yields remaining elevating (and even rising higher). This has led to the NASDAQ 100 being one of the top performing indices globally, helping TQQQ rally strongly.

While this is “good” news, it does beg the question on whether or not this relationship can last. Historically, we have seen the NASDAQ 100 under-perform when yields go up. But year-to-date this has been the opposite:

Of course, readers might counter that yields are going to go down in the near future and that makes this concern moot. That is a fair outlook, but I would suggest this is not a foregone conclusion. That is because the CPI data out of August shows that oil and energy prices more broadly are pressuring consumers in a big way. This is leading to an uptick in CPI (after a few months of declines) that could sway the Fed away from too dovish of a policy stance:

What I am getting at here is that treasury yields are likely to stay elevated – or perhaps even rise further – over Q4. That means that the changing relationship between the NASDAQ 100 and treasury yields will remain tested in the short-term. If the trend in 2023 continues, that is great for investors in TQQQ. But I would surmise a reversal to historic norms is the more likely scenario. This could pressure the underlying index and limits the gains I would expect from this fund going forward. This supports my “hold” rating.

Consumers Feeling A Pinch

Another factor to consider is that the NASDAQ 100 is not all just “Tech”. While this is the most dominant and important sector to be sure, we should also consider the Consumer-oriented exposure as well:

For this reason we should consider the underlying environment and its impact of US consumers. First off – let me say I am not trying to be alarmist or overly bearish here. Just because I am tentative with regards to leveraged/risk-on funds does not mean I advocate selling off positions and hiding under a rock. Quite the contrary. But I am suggesting caution because there are some metrics out there that could give some investors sleepless nights.

One in particular is the impact higher interest rates are having on US households. While consumers have been quite resilient in 2023, the net interest burden has been rising. While still within historical norms, it represents a spike from the last few years:

What this is showing is that US households are devoting more of their incomes to making good on their debt obligations (via higher interest rate charges). Thus far they have managed and that has helped the share prices of Consumer/Retail companies. But the verdict isn’t completely out yet. If we see more job losses, slower wage growth, and/or continued higher rates, this story could darken.

My takeaway is that the risk-reward proposition is getting a bit less favorable for Q4. That is not what I want to see before undertaking a 3X leveraged position through TQQQ.

Valuations Are Stretched – No Getting Around It

My final point concerns valuation. This is something that investors seem to be ignoring in 2023 – perhaps to their own peril. When it comes to Tech and the NASDAQ 100, we should acknowledge this sector and index do not trade like many others. Elevated valuations and premiums are more the norm than not, so traditional comparisons are not always useful. But, even still, understanding when and when isn’t a good time to buy partially does depend on how much you are paying for this exposure.

In that mindset, I want to emphasize why my followers should pay close attention to current levels. They look quite stretched even in isolation. Neither the S&P 500 nor the NASDAQ 100 are cheap, but the NASDAQ 100 is much more expensive (as a recent blip from Bloomberg shows us):

This is worth mentioning because the S&P 500 is seeing an elevated P/E largely due to some of the same names (Tech mega-caps) as the NASDAQ 100. Yet, the NASDAQ 100 – and TQQQ by extension – still trades at a much loftier price. That should raise eyebrows, to say the least.

To put all this in perspective, let us consider current P/Es for various indices and their normal trading patterns:

What I see here is that the NASDAQ is the most expensive in terms of the stated P/E and also in terms of how elevated it is compared to its own 5-year median. If this isn’t a sign to warrant some caution, I don’t know what is.

Bottom-line

TQQQ sees its share of ups and downs over time because of its structure and the nature of the index it tracks. Yet, over the past quarter, the neutral take on the long was vindicated because its return has essentially been flat.

Looking ahead to the end of the year, I’m not bullish enough on Tech shares to really get aggressive (such as through TQQQ). Valuations are very stretched, the US consumer (and corporations) are facing much higher borrowing costs, and recent inflation figures could mean the Fed keeps rates elevated going forward. The conclusion I draw from all this is that a “hold” rating on TQQQ is still the right mindset to have going forward.