How to Play a Fed Rate Pause: Go Long the Nasdaq 100^®

Key Takeaways

• As interest rate hikes taper, growth stocks’ fundamentals have improved while sectors like financials have come under pressure.
• The downturn of 2022 overshadowed several supportive long-run trends for the Index, including the move to electric vehicles (EVs), renewables, industrial automation and AI.
• The BMO Nasdaq 100 Equity ETF Fund provides Canadian investors broad exposure to U.S. growth and innovation stocks that have consistently outperformed the broader market.

This year has seen technology shares bounce comfortably off the lows of 2022—the Nasdaq-100 Index^® is clear evidence of that. What’s driving the rebound?

MM There are a few things going on that in many ways are the mirror image or opposite of what we saw last year. You simply can't discount the impact that inflation coming down is having on many Nasdaq-listed stocks. That’s given the Federal Reserve the ability to tell the market that this monetary tightening cycle is pretty much done. There is still uncertainty as to whether rates simply stay at this high plateau for an extended period, or the Fed is forced to start cutting rates in the face of a slowdown this year or next. But what we’ve seen from markets in general, and the Nasdaq in particular is that a significant weight has been lifted off growth equities. The Nasdaq-100 is not a growth index per se, but it does disproportionately skew towards that factor. Last year, when we put out research trying to help investors understand how this Index would react in a rising rate environment, we laid out the math. Every 75 bps hike—which is what the Fed was doing for most of last year—shaves off roughly 7% in terms of the present value of $1 in earnings 10 years out from today. The Fed lifted rates by 0.75 percentage points five times in the current cycle, which should have corresponded to a 35% reduction in the Nasdaq-100 Index. What happened? It finished down about 33%. Now, as investors re-position for a flat to falling rate environment, you’re seeing almost exactly what our models have predicted: a rebound based on the return of favourable fundamentals at attractive valuations; earnings, lower leverage ratios, high degrees of pricing power—all of these things are advantageous for Nasdaq-100 versus something like the S&P 500, which doesn’t hold the same growth tilt.

Consider the rise in generative AI that has propelled names like Nvidia, which is now the fifth biggest holding on the Nasdaq, almost doubling year to date in terms of price. That certainly helps drive index performance. There’s also been some other supports, such as the March banking crisis. When Silicon Valley Bank went under, the Nasdaq-100 outperformed the S&P 500 and the Dow Jones Industrial Average and had its longest consecutive daily streak of outperformance versus the S&P 500 since 2017. So as rate hikes have tapered, growth’s fundamentals have improved while other sectors have come under stress, this Index has moved back to being a kind of safe haven, not unlike what we saw three years ago when the pandemic first arrived. There’s no exposure to financials by design. And secondly, a lot of people just view those big tech names as ports in the storm.

The first-quarter earnings season delivered many upside surprises from Nasdaq-100 companies. Are there any observations investors can takeaway from this reporting period with respect to the rest of the year?

MM Q1 earnings came in quite a bit better than analysts and consensus estimates were anticipating. What’s important for people to understand is that COVID was such a big disruption to so many different areas of the economy, including causing a significant and pronounced slowdown in spending on technology across enterprise and consumer throughout the first three quarters of 2022. At the time, that looked like a flashing-red signal that maybe this was the start of a pretty nasty bear market. But to me and to certain people who've been following the space, we understood that a big part of that was just normalization from COVID. Spending was brought forward in 2021 in a big way, which of course would adversely affect growth rates in 2022, which is what we got—a temporary deceleration. That short-run weakness in turn overshadowed some pretty significant longer-run secular trends, like the move to EVs, the move to renewables, industrial automation and AI, which are what will propel growth for the Nasdaq-100 over the course of the next decade, regardless of what happens in terms of a temporary slowdown.

At the same time, last year brought about a tremendous amount of cost rationalization. Certain companies like Meta Platforms, who really took market feedback seriously in terms of cost discipline, and boosting bottom-line growth and being more disciplined. And you’re seeing all of that now coming to the surface— Meta had a tremendous positive reaction to earnings. Apple's reaction was fairly good. Microsoft's was exceptional for such a large company. We may not be in a bull market cycle like we witnessed a couple years ago. But it's not the depths of a tech recession, like we saw 20 years ago either.

For that Advisor or client who may not have a full understanding of the Nasdaq-100 and its component companies, or its history, can you sketch out a brief origin story from the Index’s beginnings to where it is today?

MM Absolutely. I’ll start by saying that it’s a very young Index relative to comparable options like the S&P 500, not just in terms of how long it’s been around, but in the companies that are listed. Nasdaq as a company was founded in 1971, becoming the world's first electronic exchange, and launched the Nasdaq Composite, which is the broadest benchmark we have. The Nasdaq-100 itself was launched in 1985. By that point, you had a couple of big names that had gone public, like Intel and Apple. Microsoft would go public the following year followed by other American blue-chip firms, including Cisco in 1990 and then Amazon in 1997, respectively. As we moved into the 2000s and 2010s, we would see Alphabet Inc. (Google), Meta Platforms (Facebook) and Tesla choose the Nasdaq to go public. These are some of the biggest names in the Index—the top seven issues comprise around 50% of the Index weighting. So the Index has really grown and evolved along with the exchange over the past three and a half decades into a position that today, the majority of technology-focused firms—certainly the biggest and most important ones—have listed with us, and continue to do so. Consider a sector like biotech, for example, where we have something like a 98% IPO win-rate. That shows how intertwined this exchange is with the most innovative companies, those new-economy firms that are propelling economic growth.

Let’s look at risk for a moment. An investor may look at the performance of some technology stocks in 2022 and surmise that they are volatile investments. What is the risk profile of the Nasdaq-100?

MM There’s definitely a cohort of investors that lived through the internet bubble in the late 90s and early 2000s, that are still somewhat anchored to this notion of, ‘Well, it's the Nasdaq. It has to be riskier than something like the S&P.’ Unfortunately, that’s just not true. As an example, let’s look at annualized volatility on a trailing 15-year basis. The difference between the Nasdaq and S&P 500 is around 2.5%, so two-hundred and fifty basis points. And when you look at the return differentials, annualized, it's quite a bit more than that in favour of the Nasdaq—sitting at over 4%. The outperformance of the Index over the past 16-17 years, after the end of the dot-com bubble established a new base to build a bull market off of, is more than two times the cumulative total return versus the S&P 500. It's been more than 2x for many years, and continues to be, even though we took a step back last year—and the Nasdaq-100 has made a lot of that decline back. What are you getting for that return? Concentrated exposure to new-economy sectors; disruptive tech, consumer discretionary, and bio-healthcare comprise 80% of the Index. Investors are gaining exposure to what we think are long-term secular trends that are very favorable for fundamental growth for not only top-line revenues, but earnings, dividends, buybacks—all that good stuff. Performance is driven by fundamentals, and fundamentals is driven by innovation. We look at this data day in and day out, and make the case to our clients about the factors that are responsible for driving that outperformance over the past decade and a half. And we feel very good about that trend continuing into the future.

Are there characteristics of the Nasdaq-100 Index that make it a more suitable option for technology exposure compared to indices or specific funds with a similar technology tilt? What are some key differentiators?

MM The simplest way to think about it is, when you look at a traditional sector definition of technology, the Nasdaq-100 is anywhere between 50-60% of that. A lot of people may be surprised by that percentage. You hear Nasdaq and assume 80, 90 or 100% if you go by that traditional sector definition. The Nasdaq-100 is much more diversified than some investors assume. You've got those top three new-economy sectors, which add up to around 80% of the Index weighting, and then you've got a few other sectors that fill in the rest, like telecoms, industrials, even some consumer staples. So, from a pure diversification standpoint, I think the Nasdaq-100 is much more attractive than going with a pure tech strategy. And certainly, I think on a risk-adjusted basis, it's better. But at the same time, you're getting something that I think is very unique in terms of the exposure, because you've got mostly growth, but infilled with some value, as well. We don't specifically screen for companies to include in the Index based on meeting various definitions of what makes a company a growth company in terms of sales, or a screening process that you'd find in a Factor ETF or a growth mutual fund; we don’t score companies based on specific growth metrics.

The Nasdaq-100 simply takes the largest companies that are listed on the exchange. And it happens to give an investor year in and year out a very consistent, very similar exposure to innovation and growth stocks. So, the profile is very unique in our view, because the main driver of what gets included on the Index is exchange-driven, it’s not subject to arbitrary rules around what a fund or screening model believes is a growth company, or what is a tech company. Is Amazon, a tech company? Some sector classifications call it a tech company, others consider it to be consumer discretionary. What about Netflix? Tesla's a similar story. So, while some investors may associate the Nasdaq-100 with pure-play technology, or IT or biotech or consumer tech, the reality is, the Index represents a core holding for any investor seeking innovation-fueled, diversified growth.

Excellent, thanks so much. Lastly, we sometimes ask our Portfolio Managers and Subject Matter Experts if there is a relevant book or podcast they can point to that may be of interest to our Advisor audience. Is there anything you’ve read or listened to lately that you’ve found instructive on markets or investing?

MM I’ll go with a podcast. I go through spurts where sometimes I’ll listen to a lot, and other times I just don't have the time. Right now, I like Odd Lots from Bloomberg. I think they do a tremendous job of keeping the guestlist relevant to whatever's happening in the market. The topics are interesting, but often not something core to my interests. So it teaches me something. For example, I'm not necessarily a crypto guy, but sometimes they'll do several episodes in a row about crypto. Another example: they did some very informative episodes on the lumber industry, when we had a massive shortage in the U.S. and Canada during COVID, to try to understand how the mechanics of that industry work, and how it impacts things like new housing construction. Other times, they’ll cover semiconductors or inflation or monetary policy. I'm a big fan.