Soon autumn leaves will do their best impression of this year’s U.S. stock market— a lot of falling.
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Barring a miraculous late year run, the major indices will finish in the red for the first time since 2018. That means the ETFs that track them, will drag down many investment account values after three years of double-digit gains.
Over the next four months, two of the most popular ETFs, the SPDR S&P 500 ETF Trust (NYSEARCA:SPY) and the Invesco QQQ Trust (NASDAQ:QQQ) will be battling it out for the dubious honor of 2022 “winner’. Together the funds hold more than $500 billion in investor assets.
Last year’s race came down to the wire with SPY sticking its nose out for a 28.7% to 27.4% victory. It ended a four-year winning streak for QQQ including 2020’s 48.4% to 18.3% drubbing.
Despite their potential to produce dramatically different returns, SPY and QQQ do have a lot in common. Since 2000, the correlation of their annual returns is a remarkably high 0.92. That makes sense considering more than three-fourths of QQQ’s holdings are also in SPY—and the top holdings are very similar.
Yet there also some subtle differences that can account for major performance disparities. It is these differences that will determine if SPY (down 17.4% year-to-date) holds its lead on QQQ (down 25.8%) and notch its first back-to-back title since 2005-2006.
#1 Risk-On or Risk-Off?
If the economy fends off recessionary pressures and inflation shows signs of cooling this would likely be a welcomed development for equity investors. In turn, a less hawkish Fed would be icing on the cake. This could lead to improved consumer confidence and market sentiment. The opposite scenario of persistent inflation, deep recession, and aggressive Fed policy could make things worse.
In the bullish case, stocks would return to “risk-on” mode. The advantage would go to QQQ. Why? The Nasdaq-100 index tends to do better when markets head higher. This reflects the higher risk nature of its components and its 1.29 beta relative to the broad U.S. market. Under the bearish scenario, the less risky S&P 500 tracked by the SPY would probably outperform.
#2 Sector Performance
We often hear the Nasdaq called the “tech-heavy’ index and indeed it is. Almost half of its weight is in the technology sector. In the S&P 500, technology names account for around one-fourth of the benchmark.
In both cases technology is the largest sector weighting, but it is the double weighting in QQQ that accounts for much of its day-to-day return differences with SPY. Tech has been the worst performing sector so far this year and a big reason why QQQ is lagging. More of the same would all but clinch a W for SPY, while a fourth quarter tech rally is QQQ’s best hope for a dramatic comeback win.
The energy sector could also be a factor. By far the best performing economic group year-to-date, even SPY’s 4% energy weighting could contribute to outperformance. There are no energy names in QQQ.
Then there are financials. They are the third largest sector in SPY at a 13% weighting but represent less than 1% of QQQ. Strong bank earnings reports boosted by higher interest rates could really help SPY distance itself from QQQ.
#3 Big Stock Influencers
At the individual stock level, SPY and QQQ appear to be close cousins when comparing their respective top holdings. In fact, the top five are identical—Apple, Microsoft, Amazon, Tesla, and Alphabet. What isn’t identical though is how much the big five are weighted in each fund. They command more than 40% of the QQQ portfolio. In SPY their combined weighting is a more diluted 22%.
This means that the relative weighting of these lead horses can create some major return differences. Apple is the prime example. It has a 13.7% weight in QQQ and a 7.3% weight in SPY, a difference of 6.4%. So, when Apple shares outperform the S&P 500, the Nasdaq, and thereby QQQ, has a good chance to outperform.
The same goes for stocks like Microsoft, Amazon, and Tesla which have significantly larger weights in QQQ. Unfortunately for QQQ investors, all three have underperformed SPY year-to-date offsetting Apple’s modest outperformance.
Putting weights aside, 62 of QQQ’s 102 holdings are lagging SPY year-to-date. This in addition to the risk-off trade, tough year for tech, and certain mega cap underperformers has made it virtually impossible for QQQ to gain ground on SPY.
A summer run did help QQQ briefly close the gap on SPY before Fed Chairman Powell’s hawkish tone relinquished about half of its gains. Since the bull-market friendly QQQ has beat SPY more often than not over the last 20 years, it should never be counted out. But a lot will have to fall into place for the tech-dominated fund to win in 2022.
