TQQQ: This Is Not The Time For Leverage (NASDAQ:TQQQ) (2024)

Investment Thesis

Over the past 15 years, the Nasdaq-100 has displayed stellar performance, especially during one of the longest bull runs ever from 2009 to 2021. One particular fund, the ProShares UltraPro QQQ ETF (NASDAQ:NASDAQ:TQQQ) has achieved even greater returns during that period because it attempts to create the daily effect of 3x the performance of the QQQ (QQQ) using derivatives such as swaps and futures.

However, we think investors may be blinded by recency bias and the performance of the QQQ over the past 15 years, and in our opinion are playing with fire by taking positions based on the current fundamentals and bubble indicators we see after this historically long period of outperformance. In this article, we describe what we think is next for both the QQQ and the TQQQ, why we think losses at current levels could get worse, and at what levels we think it makes sense to initiate positions in TQQQ.

Lessons From 1999

First, we think that if you take anything away from our research, it should be the fact that the returns you currently see from this fund may be misleading to some investors. After all, this particular fund was launched in February 2010, not too far after the 2008 global financial crisis, or right after the "lost decade" for U.S. stocks between 1999 and 2009.

For context, the Nasdaq-100 was trading in February 2010 at the same level it was at the end of the year in 1998 and was still recovering from the dot-com bubble when it burst in March 2000. However, the subsequent 11 years since the fund's inception in 2010 would be described as almost miraculous. Looking at the return of the underlying index QQQ, it currently stands at 17.38% for the past 10 years. This is quite a divergence from the 8.94% annual returns since inception and shows how unusual the period since 2008 has been. In contrast, the 3x levered ETF achieved 34.50% annual returns over the past 10 years, which may confuse some investors because it is not 3x the 17.38% annual returns that the QQQ achieved over the same period.

One explanation for this is the fact that TQQQ attempts to replicate 3x the return of QQQ for just one day. In other words, in long-term investing you have to take into account the compounding nature of daily returns in both directions, up or down. This effect can work wonders in long-term bull markets with small declines like the one we had between 2008 and 2021, but can be the exact opposite in declining markets like the one we had in 2000. Investors often forget that negative returns also compound with these leveraged ETF's.

Since the TQQQ ETF doesn't go all the way back to 2000, we ran a backtest to roughly simulate what a drawdown would look like if you invested at the March 2000 peak with $10,000. The results: for the 3x leveraged ETF, the initial $10,000 was worth only $4 at the bottom in September 2002 or a 99.96% loss compared to the normal index which went from $10,000 to $1892 in the same period or an 81.08% loss. This simulation also does not correct for elements such as tracking error or the fund expenses, which are currently 0.86% for TQQQ compared to 0.20% for QQQ.

Note that when investors are down 50%, it takes 100% gains to get back to break-even. To say that it would take investors a long time to convert that $4 back into $10,000 is an understatement, even with leverage. If you had held those shares until today, you'd only have $1,786 in TQQQ, as opposed to the regular QQQ, which would be worth $37,433. What we are saying is not that investors shouldn't buy the ETF, but that these leveraged ETFs should only be used during certain periods when it makes sense.

Because on the other hand, if you had invested at the low point after the 2008 global financial crisis when everyone was panicking, you would have been wonderfully rewarded. In our backtest, a $10,000 investment in January 2009 would have turned into a mind-boggling $10,276,663 at its peak in December 2021 for a 3x levered Nasdaq-100 ETF. The underlying Nasdaq-100 ETF didn't do badly either, turning $10,000 into $150,957 over the same time horizon.

Taking all the preceding data, investors naturally see that you want to avoid investing during a bubble period, which is usually followed by a long period of negative returns that essentially turn your investment into an amount close to 0, as it was in 2000. The chart below also illustrates the brilliant timing of the TQQQ fund's launch in 2010, as the recovery from the lost decade for the Nasdaq-100 began in 2009.

Since the Nasdaq-100 has not been around for most of its history, we can also look at what the drawdown from all-time highs has been for the S&P 500. Below, we can see that a few periods in history such as 1929 and the early 2000s also had periods where leverage at the beginning of the period would have led to huge losses for investors. Similarly, the period from 2008 to 2020 was one of the longest bull markets ever and had virtually no major leverage losses. We think this kind of extreme outperformance, similar to the 1920s and 1990s, is likely to be followed by a prolonged bear market, making investing in TQQQ too risky at this time.

A Storm Is Brewing

Some of the indicators we see support our belief that we could be facing both a bubble in the Nasdaq-100 and a recession. For example, we looked at the relationship between Nasdaq-100 and Russell 2000 (IWM), which in recent months reached new record highs not seen since the dot-com bubble. While the story in 2000 was clearly a bubble in technology stocks that inflated and deflated very quickly, we think it could be a different story this time around.

This time the Russell 2000 has performed extremely poorly over the past 5 years, almost flat, compared to the Nasdaq-100 which has had its performance led by "the magnificent 7" such as Apple (AAPL), Nvidia (NVDA), etc. The Russell 2000 can also be categorized as an index composed of many unprofitable companies and high debt at a time when interest rates are rising again to levels that have been high for decades, which is a recipe for bankruptcy.

So while a high ratio of Nasdaq-100 to Russell 2000 may be justified, it is still very noteworthy that virtually a huge chunk of Nasdaq-100 performance comes from the "Magnificent 7." Currently, the top 8 companies make up 46.86% of the index, which still raises concerns about concentration risk, even after the rebalancing earlier this year. Before the rebalancing, the top 5 securities made up about 45% of the index, whereas now they cannot exceed 38.5%.

Secondly, the weight of securities outside the top 5 cannot exceed 4.4% either. This means that the returns of the Nasdaq-100 in the future are less likely to be dominated by the returns of these exceptional companies in the top 10 that have been exceptional for the past 10 years. With these rules, smaller companies are more likely to contribute to the performance of the index, meaning that the paradigm of the "magnificent 7" generating huge returns may be coming to an end. We have also seen this phenomenon in the S&P 500, where the "MegaCap-8" has contributed massively to the overall index, even though the S&P 500 consists of roughly 500 companies.

If we look at the 12-month moving P/E ratio for the Nasdaq-100 according to Barron's, we see that it remains at 29.63, much higher than the average for the index since 2010, which is closer to 21. And it is certainly far from the average 16x gain the S&P 500 has had in modern history. Speaking of which, the average inflation-adjusted P/E ratio over the past 10 years for the S&P 500, or CAPE Ratio, still stands at 29.64x.

The last time this ratio was this high was in 1929 and during the dot-com bubble in 2000. Over the past 20 years, these valuations may have been justified when interest rates were close to 0%, but with 10-year government bond yields hovering between 4.5-5%, we don't think these high valuations are justified.

The Opportunity

While we believe that the current environment is not enticing for TQQQ, we do believe that a great opportunity is developing, likely to present itself sometime in 2024 or early 2025. Right now the yield curve is "un-inverting", which means we are actually on recession watch, because a yield curve so inverted always meant that a recession was in the cards.

Although we have already seen bearishness at this point with long-term rates rising, we believe the Fed will soon lower short-term rates as unemployment rises. In terms of what the drawdown might look like during a recession, we may not see the -80% drawdown of 2000 or the -50% decline of 2008-2009. But with the combination of valuation multiples near 30x earnings and interest rates that have been artificially low for decades, we think the bottom is not yet in sight for the index and expect at least a -40% retracement from the all-time highs.

Even if earnings remained flat during a hard landing, a drop in the P/E ratio on QQQ from the current 29.64x to the historical average of 16x for the S&P 500 would already represent a 46% decline. A return to the baseline since 2012, which includes the entire period when interest rates remained at artificially low levels on 21x earnings, would still represent a drop of nearly 30% from the all-time highs to around the $280 level for QQQ.

In fact, we find it very odd that after returning to baseline from elevated multiples in 2020 and 2021, the index is now trading at the same elevated levels again while Fed Funds have moved from 0% to 5.50% as the yield curve continued to invert even further. The market rallied perhaps in response to the fact that the end of the current hiking cycle is likely in sight. Personally, we think that the next downward move is right around the corner and that investors should look out for unemployment figures to move higher.

Looking back to 2008, the QQQ also plunged 25% from $48 in late 2007 to $36 in early 2008. Then there was a rally in the first half of 2008 that fooled many investors as the QQQ rose more than 22% from $36 to $44. However, this huge head fake led many investors to believe that the recession was already over, which would have been a rude awakening as the index fell from $44 to $24 over the next 6 months.

As in the dot-com bubble of 2000, the second downtrend is arguably the most brutal and overwhelms most investors, because most investors look forward to a recession when the curve first inverts, while the most dangerous period is actually the "un-inversion" when the Fed cuts interest rates.

In terms of specific price ranges at which we would be inclined to buy, we see opportunities for TQQQ if QQQ were to return to the $280 range. We would be more focused on entering the trade if the price ever fell below $240, with $230 as a potential target from a bottom. In our worst case scenario, if QQQ were to crash as it did in 2000, but this time with the bursting of the "Megacap-8" bubble, our worst case scenario would be $180.

This would mean that QQQ would go all the way back to trend from 2019 and trade completely flat for 5 years, just as it did from 1997 to 2002. As a reminder, we ran backtests and saw that even if investors nailed the bottom of the Nasdaq-100 in September 2002 and bought TQQQ, they would still be lower than normal QQQ during the 2008 recession. So we would also be wary if the yield curve reversed again in the next recession after this one, and we would see it as an opportunity to exit when the yield curve reverses back to normal, and re-enter the position when QQQ drops significantly during that recession.

The Bottom Line

Although the TQQQ could still rise in the short term as investors speculate that the Federal Reserve is done raising rates and is at the end of this rate hike cycle, we believe, as we often do, that this is a head-fake and that a recession is most likely coming in 2024.

Looking at the results of our backtests that we have conducted, we also believe that instruments such as TQQQ should only be used in certain scenarios such as recessions when indices fall significantly. Some backtests that use a dollar cost averaging method can produce great results, but we find them untrustworthy since most people use the current period, the top of one of the longest bull markets ever, as the end period for the backtest. If we ran the same backtests using a DCA method in different time periods for TQQQ, such as from the beginning of the Nasdaq-100 in 1985 to 2010, the regular QQQ would have performed better and shown less volatility.

The current recency bias, along with certain bubble indicators we have highlighted, leads us to believe that investors at current levels would be playing with fire by buying into triple leveraged ETFs after one of the largest periods of outperformance. Still, we think there are opportunities should QQQ fall to $280 or lower during a recession.

The first rule of an investment is don't lose money. And the second rule of an investment is don't forget the first rule. And that's all the rules there are. (-Warren Buffett)

Wright's Research