Stocks rallied yesterday ahead of today’s key inflation data as investors look beyond a now-expected additional rate hike. Crude is bubbling higher as stockpiles shrink and the Saudis continue to unilaterally cut production.
Get on the Q. Have you heard of the “Q’s”? The “Q’s” is a nickname given to the exchange traded fund (ETF) QQQ which tracks the Nasdaq 100 Index. So, I am guessing that you probably have heard of the Q’s. The Nasdaq 100 is considered by many to be the benchmark of the tech world. It is composed of the largest 100 non-financial, stocks traded on the Nasdaq exchange. Based on its recent rally, or even its behavior over the past 15 years, I am sure that you already know that the Index without financials, is dominated by tech stocks, which is why you often see the Index described as, even in this very note, the tech-heavy Nasdaq. The reason for this even goes beyond the Index’s components but additionally to its weighting methodology. You see, the Nasdaq 100 uses a modified capitalization-weighted method for weighting.
At a very basic level, cap weighting is accomplished by dividing the market capitalization of an index’s member by the total market capitalization of the index. Makes sense, right? Using this formula, you will quickly note that the biggest companies have the biggest influence on the performance of an index, and that influence increases if those companies continue to grow. This has sparked a lot of criticism from “numbers people,” who argue that cap-weighted indexes do a poor job at representing “the market” due to the heavy influence of a small group of stocks. The “investment people,” as you may guess, don’t have any argument at all… assuming they have been on the buying side of the QQQ.
This back and forth between the theorists and investors has been thrown into sharp focus recently. I have, indeed, written several times about the discrepancy between the S&P500, also a cap-weighted index, and your probably sound-but-underperforming-portfolio… unless, of course, your portfolio was overweighted in mega-cap tech. The Nasdaq 100 just had its best 1st half of the year performance… EVER! So, if you have heard of the Q’s and, better yet, owned the Q’s, you would feel pretty accomplished with your investment selection skills.
Let’s get back to the weighting methodology. Cap-weighting means that as companies grow their influence on the index gets more prominent, and vice versa for those companies that lag. The methodology, therefore, seems sound, as the index represents the “cream of the crop,” so to speak. There are certain times however where the influence of a few stocks appears to be out of touch with reality. The past 6 months has witnessed a fantastic rally of tech stocks, specifically mega caps. After last year’s performance, the AI frenzy started earlier this year spurred a buying frenzy which was narrowly focused on, you guessed it, tech. The top-weighted stocks on the Nasdaq 100 are (in order) Microsoft, Apple, NVIDIA, Amazon, Tesla Meta, and Alphabet. These have been referred to as the magnificent seven for obvious reasons. If you remove Meta from the list and count both classes of Alphabet, the remaining 6 make up 50% of the weight on the index! Why did I leave out Meta?
Going back to the top of this morning’s note, you will see that I described the Nasdaq 100 as a “modified” cap-weighted index, which means that the keepers of the index can impose additional modifications to the basis cap-weighting math. They do this to ensure that no one stock, or group of stocks has an overbearing influence on the overall index. These modifications can include weight caps. You may not believe it, but the Nasdaq has made modifications in the past. A notable one was in 2011 when Apple was trimmed to 11% from 20%. I’ll bet that you didn’t know that and if you did at the time, you may have thought it a travesty to the free markets.
The reason for this large discourse is that Nasdaq has decided to do a “special rebalance” of the Nasdaq 100 to lessen the influence of the magnificent seven excusing Meta. That’s right, 6 of those 7 big shots are going to be knocked down in size on July 24th. What does that mean for you? Well, if you own the Q’s, the ETF will perform more like a broader index. BUT if you own any of those 6 soon-to-be-kneecapped stocks, you may find that they will be under pressure. You see, in order for QQQ to remain in sync with the Nasdaq 100, Invesco, the ETF’s manager will have to trim down its positions in those stocks to match the new, as yet undisclosed weights, dictated by Nasdaq. That also means that those other 94 stocks may get a boost as the managers bring those up to policy. Here are some numbers for you to take away. The Nasdaq 100 gained +38.75% in the 1st half of 2023 while the Nasdaq 100 Equal-weighted Index only rose by +21.20%. The QQQ ETF has $204 billion in assets with 554 million shares outstanding. QQQ currently owns 77 million shares of Microsoft… it will own less on July 25th.
STOCKS ON THE MOVE THIS MORNING
Dominos Pizza Inc (DPZ) shares are higher by +6.20% in the premarket after The Wall Street Journal reported that the company has struck a deal with Uber Technologies to list its menu items on its Uber Eats and Postmates delivery services. Dominos is the largest Pizza chain in the country and stands to gain a large distribution channel to augment its ubiquitous delivery fleet. Dominos will announce its Q2 earnings next week. Dividend yield: 1.38%. Potential average analyst target upside: 0% (not a typo).
Cisco Systems Inc (CSCO) shares are lower by -1.53% in the premarket after BofA downgraded the stock to NEUTRAL from BUY. The BofA analyst believes that forward earnings expectations are too unrealistically high setting the stage for future disappointments. Cisco will announce earnings next month. Dividend yield: 1.53%. Potential average analyst target upside: 9.2%.
YESTERDAY’S MARKETS
Stocks rose yesterday as fears of Fed hikes may be easing and ahead of this morning’s CPI release. The S&P500 climbed by +0.67%, the Dow Jones Industrial Average traded higher by +0.93%, the Nasdaq Composite Index advanced by +0.55%, and the Russell 2000 Index jumped by +1.03%. Bonds rose and 10-year Treasury Note yields eased by -2 basis points to 3.97%. Cryptos lost -0.88% and Bitcoin declined by -0.67%. The S&P ESG Index gained +0.61%.
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