It has been a brutal start to the year for stock market investors.
In fact, the S&P 500 has had its worst start since 1939, with a drop of over 16% year-to-date. And the once high-flying technology sector is feeling even worse.
Even with Friday’s nearly 4% relief rally, the technology-heavy Nasdaq has fallen by more than 25% year to date.
Many of the technology names that dominated portfolios and performed better through most of the last decade have seen their stocks plunge in 2022. This includes the so-called “FAANG” stocks – Meta (FB), Amazon (AMZN), Apple (AAPL), Netflix (NFLX) and Alphabet (GOOGL).
On average, the FAANG share has fallen by approx. 37% since the beginning of the year.
Promising technology startups like retail investment platform Robinhood and electric car maker Rivian have also taken a dive, and technology names like Peloton and Zoom, which thrilled investors during the pandemic, have seen rising losses.
This year’s tech route has made many market observers wonder what happened. From fears of recession to rising interest rates, it is obvious that technology stocks have faced a number of headwinds. But should the losses really be that bad?
Some experts claim that the tech sector is now oversold, but the reality is that tech companies may still have the odds against them. Here’s why.
A year of macroeconomic headwinds
First and foremost, technology stocks have been hammered by a number of macroeconomic headwinds–the war in Ukraine, COVID-19 lockdowns in China, tight supply chains, soaring inflation, declining economic growth, and the list goes on.
As Wedbush’s technology analyst Dan Ives wrote in a Friday note, this is “probably the most complex macro background in 100 years.” On top of all that, you have a new “social media world” where every data point can be microanalyzed by millions, affecting the markets in seconds.
This is not good news for stocks in general, but technology stocks are facing even more headwinds than most. After all, in times of economic pain, it is not the idea of most investors to make money wisely in often very speculative risk assets.
Instead, many seek “safe haven” to protect their portfolios, as evidenced by the out-competition of value stocks and the growing demand for gold in the first quarter. This is bad news for the technology sector.
During this week’s brutal stock market sales, technology stocks suffered their biggest retreats of the year, with investors taking $ 1.1 billion out of the sector, according to Bank of America strategists led by Michael Hartnett.
It’s a sign of “true capitulation” when investors drop their most beloved holdings they have this week, Hartnett and his team said.
“Fear and loathing suggest stocks are likely to face an impending rally in the bear market, but we do not believe the ultimate low has been reached,” the strategists added.
A ‘hard landing’
Investors are also worried that a recession may be on the way as the Federal Reserve raises interest rates to fight inflation. The central bank has tried to ensure a “soft landing” for the US economy, where inflation prevails, but growth in gross domestic product (GDP) continues.
But now even Fed Chairman Jerome Powell admits it could be “pretty challenging.” As a result, both institutional and retail tech investors have been heading for exits.
“We believe these stocks are pricing a ‘hard landing’ with fears abounding,” said Wedbush’s Dan Ives.
It’s no wonder why, really. History shows that soft landings are extremely difficult to accomplish.
“Over the last 70 years, there have been 14 episodes of Fed tightening and 11 recessions of soft landings on just three occasions, or 21% of the time,” Lisa Shalett, Morgan Stanley Wealth Management CIO, said in a Monday memo.
The Fed is trying what Shallet describes as an “unprecedented feat,” while raising interest rates and reducing the size of its balance sheet to nearly $ 9 trillion.
Throughout the pandemic, the Fed kept interest rates close to zero and leaned into a somewhat controversial policy called Quantitative Easing (QE), in which billions of dollars of mortgage-backed securities and government bonds were bought every month to increase the money supply and lend to consumers and businesses.
While QE helped enable one of the most impressive economic recovery in history from the recent pandemic-induced downturn, it also increased risk assets such as technology stocks.
Now that the “free money” era is over, technology investors are worried that we could see the dot-com bubble again. Still, Street always has its fair share of tech bulls, and many analysts claim that this tech sale will soon end – at least for most of the sector.
“In short, this is not a Dot-com Bubble 2.0 in our opinion. It is a massive overcorrection in an environment of higher rates that will cause a two-part tech band with clear technologies that have and have nothing,” says Ives .
The well-known tech bull added that he expects “there will be many technology and electricity players disappearing or consolidating,” but top names in sectors such as cybersecurity and cloud software should continue to surpass in the long run , making this a “generational buy-in” for investors willing to take on more risk.
Yet rising prices present unique challenges for technology stocks, which are often valued for their ability to increase revenue.
A tech sector that is changing prices as prices rise
Tech stocks are particularly sensitive to rising interest rates, at least in part because of the discounted cash flow (DCF) models used by analysts on the sales side to value stocks.
In short, DCF models predict the future cash flows of a business and then discount those flows back to arrive at a value for what they are worth today.
The key factor used in this discounting process: it’s right, interest rates.
This means that when interest rates rise, the present value of a company’s future earnings decreases. And the greater the expected growth in future earnings, the worse the effect of rising interest rates on a stock’s valuation.
So high-flying technology companies – which are often so highly valued not because of their profitability, but because of their growth potential – are hardest hit.
“As interest rates rise, it forces investors to shorten their time horizon and attribute less value to cash flows later in the future,” said Dave Smith, head of technology investment at Bailard. Assets. “Technology tends to have more companies evading profitability today in order to invest in future growth. These stocks have underperformed as prices have risen higher.”
Smith noted, however, that despite “major missteps” from FAANG companies and persistent macroeconomic headwinds, sustained stock market outperformance is typically driven by “organic business growth”, and this is something most FAANG names can still deliver.
“It may not be as simple as ‘Buy FAANG’ anymore, but we believe that many babies are thrown out with the bathwater in the current fear-driven environment. It is an opportunity for long-term focused investors, ”he said.
This story was originally shown on Fortune.com