Interest rate normalization
Actually, bubbles do deflate as the Fed aggressively cuts interest rates.
First, bubbles inflate during periods of loose monetary policy, usually following a certain theme that justifies unrealistic valuations. Next, the Fed starts to tighten monetary policy by increasing interest rates (usually as inflation rises), and the bubbles eventually burst as liquidity starts to dry out, and valuations start to compress.
By hiking interest rates, the Fed usually inverts the yield curve, which eventually produces a recession, at which point the bubble burst accelerates as corporate earnings shrink. By this time the Fed usually starts lowering interest rates – thus the bubbles usually continue to deflate as the Fed cuts.
Further, recessions sometimes produce systematic credit events, and consequently cause forced selling and deleveraging. The stock market selloff in this stage is the most violent and the Fed is usually cutting rates aggressively, as well as expanding the balance sheet to boost liquidity.
Thus, generally, bubbles do deflate as the Fed cuts, based on historical experience – if the Fed cuts due to a recession and/or a systematic credit event.
However, it is important to understand the purpose of monetary policy tightening.
Obviously, the monetary policy easing during a recession is intended to stimulate the economy during a recessionary period – this is when the unemployment rate is spiking. Further, the monetary policy easing during the credit event is intended to protect the financial system from a collapse – this is when the liquidity dries out due to solvency concerns. Thus, it is obvious why monetary policy easing is usually not considered a good thing for risky financial assets – it’s generally associated with recessions and credit events.
However, the Fed can also aim to implement the interest rate normalization policy. This is the situation when the initial interest rate hiking campaign does not produce a recession, while the inflation falls towards the target. Thus, the Fed can lower the interest rates to the neutral level to remove the unnecessary policy restrictions. Note, this is a very rare occurrence historically – it occurred only in 1995 in recent history.
Obviously, in this case, the risky financial assets would respond positively to the monetary policy easing. Why? There is no recession and no credit event. Note, that the stock market entered a parabolic uptrend after the 1995 interest rate policy normalization.
The point is, don’t expect bubbles to deflate as the Fed cuts interest rates – if the Fed is implementing an interest rate policy normalization, and no recession or credit event is expected.
The QQQ “bubble”
The ETF that seeks to track the performance of the NASDAQ-100 Index (NASDAQ:QQQ) is currently trading the ttm PE ratio of 29 and forward PE ratio of 28. So, this is not a bubble, but the valuations are stretched – QQQ is overvalued. Given that the big tech stocks included in QQQ are also included and heavily weighted in the S&P 500 (SPY), the S&P 500 is also overvalued with the PE ratio over 21.
QQQ is up over 50% over the last 1 year, but this super-performance follows the 30%+ bear market drop in 2022, so QQQ is at an all-time high, matching the previous peak.
Given the valuation concerns and the technical “double top” formation, is QQQ a bubble waiting to burst?
First of all, what caused the 30%+ bear market in 2022? QQQ dropped significantly in 2022 because the Fed was aggressively hiking interest rates in response to the post-pandemic inflationary shock. As I previously explained, this is the first phase of the bubble burst.
The next stage of the bubble burst was supposed to be a recession. This is when earnings drop and the valuation multiples continue to contract, possibly producing a 50% crash. The subsequent stage was supposed to be a systematic credit event, triggered by the Commercial Real Estate (XLRE) defaults and the Regional banking crisis (KRE).
But the recession never arrived, while the disinflationary process evolved faster than expected – fast enough to allow the Fed to lower interest rates without the need to induce a recession.
So, now we are facing the interest rate normalization policy – the Fed will start lowering interest rates. The risk is still that the lagged effects of the previous interest rate hikes cause a recession and a possible credit event. But if the Fed lowers the Federal Funds rate back to the neutral level quickly and aggressively, there is a good chance that the economy could slow, but not contract – no recession. Further, if the Fed lowers interest rate aggressively, the vulnerable small caps (IWM) and the REITs will not face the steep refinancing wall, and thus the probability of a significant credit event would also decrease.
Thus, it’s all about the Fed. The market expects the Fed to start lowering interest rates in March and lower the Federal Funds rate to 3% by late 2025, with most cuts in 2024. This scenario would be positive for overvalued big tech, as it would continue to support “high” valuations, while the earnings would continue to grow.
Could QQQ enter a parabolic uptrend as the Fed normalizes interest rates, like in 1995? Well, there is a GenAI theme, and if the technology implementation is broad-based and effective, everything is possible.
However, given the uncertainty of GenAI monetization at this point, and still uncertainty whether the Fed will actually be able to accomplish the soft-landing, I would HOLD for now.
The New Year 2024 started with a 2% dip in QQQ, as the market evaluated the timing and the scope of the Fed’s interest rate normalization. Thus, it is possible that the dip turned into a correction. However, I don’t expect the “crash” or a new bear market at this point – the Fed will cut in 2024, maybe not in March, but it will cut, and in this environment the “bubbles” don’t crash – as long as there is no recession, which at this point is the baseline scenario.