The first quarter of 2023 ends today, and it has been an interesting one, to say the least. As last year ended, I don’t recall all that many people expecting a positive start to this one. The Fed had made it quite clear that they were committed to the fight against inflation and would be continuing to squeeze credit conditions and hike rates. By December, the negative impacts of that were beginning to be felt, with layoffs being announced in a few companies and with weakness in the housing and other rate sensitive markets, but there was little sign of any progress in terms of prices. The outlook wasn’t pretty.
And yet, here we are, three months later, with solid gains in the broad market. Those gains, however, are far from equal. The chart below, for the ETFs that track the three major indices, the S&P (SPY), the Dow (DIA), and the Nasdaq (QQQ) for the year thus far shows a dramatic disparity in returns.
QQQ has gained 18.6%, the S&P 5.6%, and the Dow is actually in the negative, having dropped 0.9%. So why is that and, more importantly, can it be expected to continue?
Given the website on which you are reading this, it is tempting to say that the outperformance of QQQ is simply because the Nasdaq is just better than all the others, but it isn’t that simple. In fact, if you were to look at the same chart for the last year rather than quarter, you would see that QQQ is the worst performer of the three over that time span. That, however, is a big reason for the outperformance so far this year.
The tech and growth-oriented stocks that dominate the Nasdaq were hit hard through most of last year, when the conventional wisdom was that they would be hit early and hard by the change in credit conditions. The stocks were sold off as a result, but markets always have a tendency to overreact to obvious problems, and that was certainly the case in the second half of 2022. At the end of last year, for example, I pointed out that Apple (AAPL), which had just hit a 52-week low, was massively oversold given that what we were most likely seeing were temporary supply chain issues deferring purchases, not a mass move away from Apple products.
Nor was that a one off. I also wrote, early in January, that Microsoft (MSFT) looked oversold and primed to outperform. Those calls weren’t genius, they were simply based on the well-known fact that traded instruments tend to return to the mean. Without any real company-specific issues, the hardest-hit stocks in a drop have the best chance of bouncing quickly. That is what both AAPL and MSFT did, leading the Nasdaq to overall outperformance.
That explains why QQQ outperformed last quarter, but whether the level of gains in the index can be continued or not depends, as you might expect, on the Fed. If they take into account the recent wobbles in the banking sector and factor in data that are encouraging if not spectacular, and they pause the hikes starting next quarter as a result, then yes, Nasdaq stocks will post more gains. On the other hand, even one more 25 basis point hike will be seen as a negative for stocks in general and could temporarily recreate the H2 2022 selloff.
Outperformance, though, isn’t just about gains. It is also about losing less on the way down, and there are reasons to think that on that basis too, QQQ will be the best performing major index tracking ETF should Q2 be a rough one overall. Those reasons are contained in the second, one-year chart above. QQQ is still lagging the others on a one-year basis and, as mentioned, things tend to return to the mean. That difference could be made up by stronger gains in a bull market, but they could also be about smaller losses in a bear market.
So, while the overall direction of stocks in Q2 is still uncertain and depends largely on how Fed Chairman Jerome Powell and the rest of the gang at the Fed feel about the economy, investors will probably be better off buying in or holding onto the Nasdaq tracker as opposed to the Dow or S&P equivalents for a while to come. Doing that can be a bumpy ride, but in the long run, it is one that history shows pays off.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
