Stocks this week approached a bear market for the second time in just over two years. Investors seeking a culprit can, very fairly, blame technology stocks for their pain.
It has been a remarkable turn of events, shareholders of the most dominant, most innovative companies on the planet enduring losses of 30% or 40% in a matter of months. On this 2023, the US Technology Sector Index has fallen 27%, with Microsoft (MSFT) down 22%, Apple (AAPL) off 17% and semiconductor beast Nvidia (NVDA) down 44% and also Salesforce.com (CRM) which saw a drop of 37%.
Then there’s the communications sector, with household names including Facebook parent Meta Platforms (FB) down 44%, Netflix (NFLX) a stunning 73% and Google parent Alphabet (GOOGLE) down 22%. It’s a similar story among other sectors and industries, with losses like these leaving the Communications Services Index down 29% in 2022, year to date.
As investors, the market we’re in is forcing us to confront a few very important lessons about stock investing and valuations, why they matter and why they don’t. On the surface, the numbers around the tech stock losses are jaw-dropping, but there’s an argument to make that there are good reasons for their decline.
And as dramatic as the declines have been, and as unsettling as the headlines may be, it’s still important for investors to take a longer-term view of the market’s returns. It could be a very, very bad year after all. Yet 2019, and 2020, and 2021 were very, very good years.
Here are some investors playing the long game who also can use pullbacks as opportunities to take advantage of dislocations in the market and fortify their financial plan. As things stand now, according to gauges, technology stocks are the cheapest they have been since March 2009, when markets were starting to emerge from the global financial crisis.
Investors can extract several lessons from the tech stock selloff, says Tyler Dann, head of research for the Americas at Investment Management. “One major lesson is behavioral and it’s about crowding or herd mentality an investment may have tremendous merit a great business case strong growth trajectory strong balance sheet etc,’’ he explains. “But when too many people have the same mindset it can often cause a dislocation between prices that people pay for a stock and what it’s worth. And it can work both ways to the upside and downside.”
Big losses, but following big gains
These are definitely large, painful declines based on the state of the market and investor sentiment as 2021 closed. At this point, the downdraft is similar to other bear markets in history.
For example, technology stocks are down 27.2% since the top in the tech indexes on Dec. 27. It was down 16.5% in the same 138 days after tech stocks reached their peak in March 2000. In 2008, tech stocks weren’t as hard hit, but the carnage of that bear market was concentrated on financials and economically sensitive stocks, not tech names.
“It’s all a matter of perspective,” said Steve Sosnick, chief strategist at Interactive Brokers. ’ He cites Nvidia, which is down more than 40%.
“If you were swept up in the late 2021 mania push of growth stocks and tech, you’re down big,” he says. “If you’re a long-term investor, it’s done very well.” Even an investor who purchased Nvidia three years ago has nearly quadrupling their money.
That, of course, is not true for all stocks that have gone down. Netflix is one of the textbook examples of a company stock that has been pummeled in 2022, losing nearly three quarters of its worth. At the end of 2021, it had gained 125% over the previous three years. Now it’s off a 51.7% for that period.
But in general, that trend is true for both the broader tech space as well as communication services stocks. The tech stock index is still up 72% in the past three years, while communications is up 21%. Over that time the broader market is up 40%.
Until they don’t: Valuations don’t matter
What, then, became of these stocks?
“Much of this performance now is really just unwinding their excess performance,” Sosnick says.
To explain the fall of tech stocks, you have to go back to the bear market and recession of 2020, during the pandemic. As global economies were locked down and stocks plunged into free fall, investors were on the prowl for companies that would weather the storm.
A lot of these companies were and still are thought to have the kind of durable, defensive business models that were seen as relatively few and far between in the marketplace, says Dann.
“They ended up being crowded investments,” Dann says. “You can’t separate this (selloff) from valuations. Valuations include expectations. It gets at the mentality of the market.”
The herd mentality drove many mega-cap stocks to new highs and steep valuations. At the end of 2021, the price/earnings ratio of the tech stock index was north of 29, quite a bit above a 10-year average of 20. The communication services index ended the year at more than 21 times earnings, compared with a 10-year average of 18.
Once pandemic lockdowns were lifted, other forces took hold.
Investors got enamored with the notion of disruption,” he says. “It can be a really good means to an end, massive fortunes have been made based on disruption. “But eventually disruption has to become profit.”
He highlights online car dealer Carvana (CVNA). The stock surged to $360 in August 2021 from about $22 in 2020. It’s now trading below $40. “They’re very disruptive in their space, but at the end of the day they weren’t able to monetize it to a degree people would find satisfying valuation.”
Don't fight the Fed
“Returns were phenomenal in twenty-’21 and markets can remain euphoric longer than you and I might think,” adds Dann.
Trends typically need some kind of catalyst to change. In this instance, the turn came with the sudden awareness that high inflation was not transitory and that the Federal Reserve was going to have to act strongly to hike interest rates.
“The backdrop has been one of a sudden regime change,” says Dann. “The last 40 years have essentially been characterized by positive tailwinds for equity and fixed-income investors, where you have relatively low rates of inflation and relatively stable or declining interest rates.”
“This is creating me a backdrop of headwinds more than tailwinds,” he says.
As has been widely reported, technology stocks and growth-stock companies generally have been viewed as the sector most vulnerable to rising rates. That is because a fundamental part of stock valuations is projecting the present value of a company’s future earnings. Investors apply interest rates to discount those future earnings back to today, and higher rates today means lower value for earnings of the future.
Fast-growing companies, particularly in tech, tend to attract valuations based on earnings years or even decades down the road. These are called long-duration stocks. When the discount rate increases on long duration investments, what happens is what you’re going to get whacked,” Dann says.
What’s next?
At Investment Management, they’ve been “sharpening their pencils” on beaten-down tech names, especially big-company stocks where you’ll find them common in selloff punch cards.
“An exposure to these names can be achieved in a more general manner by way of purchasing the large-cap, growth-oriented indexes, yet we feel these companies specifically, in particular Meta and Google have seen a better valuation of late,” he said.
The commonality among these companies is that they exhibit strong balance sheets, abundant free cash flow generation, high profit margins, and returns on invested capital. All those are signs of high-quality businesses.
“Although growth concerns at least in the case of FB have recently started to stir, with the future trajectory of revenue and profit growth increasingly coming under the microscope, share prices have lagged the broader markets, creating an opportunity for longer-term investors that may have underweighted these shares to consider reducing that underweight,” Dann says.
Sosnick also sees opportunity in the build up among strong companies for investors. “The bad companies are being tossed by the wayside. Good companies are getting punished as well, but they’re getting punished because they had huge valuations associated with them that were not sustain-able,” he says. “You have to look at the longer-term picture. The good companies still are good companies.”
