The bear market rally
The NASDAQ 100 (NASDAQ:QQQ) is up almost 36% YTD. But let’s put this performance within context. The 2023 rally follows a deep 33% selloff in 2022.
The chart below shows that at the end of 2022, QQQ was near the October lows, below the technically important 200wma, which has been a reliable longer-term uptrend support in prior selloffs, like in 2020. Thus, NASDAQ 100 was entering 2023 in a weak technical position, which supported a deeper selloff.
Fundamentally, the 2022 deep selloff was a result of the PE multiple contraction due to the Fed’s aggressive monetary policy tightening, which I define as a liquidity shock-based selloff.
But more importantly, the lagged effects of 1) higher short-term interest, 2) higher mortgage rates (due to QT), and 3) the credit tightness due to the inverted yield curve, sharply increased the probability of a Fed-induced recession in 2023. Thus, given the highly cyclical nature of tech business, the tech sector was also in a very unfavorable fundamental situation entering 2023.
Yet, despite the bearish fundamentals and technicals, QQQ staged a sharp rally in 2023, first breaking above the 200wma resistance, and then going almost vertical following the break above the 100wma resistance (red line).
What explains the 2023 performance YTD?
First, it’s the short covering. The chart below shows the net short positions in NASDAQ 100 futures by leveraged investors (hedge funds), and we can see an increase in short positions in January, followed by short covering into March, and then significant rebuilding of short positions towards the end of May, followed by a massive short covering right into the top on June 15th.
What explains the high short interest?
As previously stated, QQQ was in a bearish technical and fundamental position towards the end of 2022. The fundamental argument for shorting QQQ was very simple:
- First, the tech earnings would have to be significantly downgraded as the expected recession hits, and tech companies were expected to lower their guidance accordingly.
- The Fed was expected to continue hiking interest rates due to core sticky inflation, deepening the liquidity shock and increasing the probability of recession, which was not priced in by the market.
What explains the bounce in 2023?
As previously stated, the bounce was supported by short covering, these were the bets on further downside in QQQ that has to be covered at much higher prices.
Further, short covering was triggered by the news that Microsoft heavily invested in ChatGPT on January 27th – that’s exactly the date when QQQ crossed the 200wma resistance, which triggered short covering due to stop loss orders. Since then, QQQ was led by megacap tech companies related to the generative AI theme, such as Microsoft (MSFT) and Nvidia (NVDA).
To further support the AI-themed really, the big tech earnings generally beat the expectations, particularly NVDA which also significantly increased the guidance., which triggered the breakout of the 100wma resistance and the subsequent vertical rise supported by short covering, but also the entrance of the retail investor into the AI-themed rally.
The net result of the AI-themed rally was the bubble-like valuation of related companies, led by NVDA which is trading at the price 40 times sales.
Why is June 15th likely the top?
Two major events happened on June 14th that suggest that QQQ reached the top on June 15th.
The Fed
First, the Fed made it clear at the June 14th FOMC meeting that due to sticky core inflation, the Federal Funds rate will have to go even higher, possibly by another 50bpt.
Thus, the bullish narrative of expected monetary policy easing in 2023 has been finally buried. The market is currently pricing one additional 25bpt hike, and it still needs to price the second 25bpt hike.
This is in-fact the original QQQ bearish thesis from the end of 2022 – the Fed will keep hiking until the recession hits. Thus, the tech earnings will have to get downgraded, and the valuations need to contract. The market likely understands this now.
The Generative AI Report
But more importantly for the genAI themed bubble, McKinsey Digital published a report on June 14h: The economic potential of generative AI: The next productivity frontier.
The report is on the surface very bullish for the gen-AI theme, and the broader economy because it predicts that genAI will add anywhere from $2.6-$7.9 trillion in value to the economy “over years”. See the chart below.
However, only a few industries/areas will benefit from genAI the most, and these are concentrated in customer service, marketing, sales, software engineering, and product R&D. Here is the chart:
In other words, genAI is about better customer service – when we call a company we will be talking to a much more empathetic robot, that’s it. Also, they will be able to target us more efficiently with the ads – please don’t. With other creative uses, there will be significant copyright/patent issues, and the entire system is facing the Garbage In – Garbage Out robot training issue. On the productivity side, the assumption is that all displaced workers by t genAI will find comparable jobs- good luck with that. Thus, the trillion dollars in productivity gains are likely overstated.
Basically, the genAI is just hype at this point. And I think the market also understood this.
Implications
The AI-themed bubble is bursting, and we are likely past the peak, which I mark on June 15th. Yes, never underestimate additional short covering and the retail investor inflows, and it’s definitely possible that the bubble reinflates.
However, given that, 1) based on net short positions in NASDAQ100 futures, it seems like the vulnerable shorts have already covered, 2) the market is finally pricing the Fed’s intent to induce a recession, and 3) the market is learning that the genAI theme is just a hype, the top in the QQQ 2023 rally was likely reached on June 15th.
Thus, a new bear market in QQQ is likely, or the old one is likely to resume depending upon how you look at it. I think it will likely push the price below the October 2022 lows.
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