Are The Best Days Over For Tech Stocks?
Big issues surrounding tech stocks
Tech stocks were the big winners of 2020. Lockdowns glued us to our devices as any stock with a vague presence in e-commerce, the cloud, or anything tech-related blossomed.
Tech stocks continued their run to start 2021. However, these stocks haven’t been the same since February 2021. Index funds recovered their losses while tech stocks, especially high growth, didn’t rebound too quickly, if at all.
Just because tech stocks usually dominate the market doesn’t mean that will always happen. Investing is cyclical, and some environments present better set-ups for tech stocks than others.
The current environment isn’t as friendly for tech stocks. It’s the reason I’ve taken profits from some positions.
Inflation Is Coming
We’ve been told since the Fed started printing money that inflation would gain steam. We began to see that inflation jumped up 5.4% in June compared to the same period last year.
Right now, the Fed is in a damage control state. If they freak out about inflation, it will create a self-fulfilling prophecy. Consumers will freak out and do many things like stockpile goods or spend their money while the purchasing power is still decent.
The Fed has put many people in a fantasy world where printing trillions of dollars doesn’t impact the value of the U.S. dollar. It’s practically an invisible, silent tax. Rather than raise taxes, why not give people a bunch of money and decrease the purchasing power of every dollar in the process?
Both objectives accomplish the same goal, although one is immediately felt (raising taxes) while the other provides instant gratification (printing money), although it did help plenty of people during the pandemic.
Regardless of how we feel about how we got here, inflation is coming. To stave off inflation, the Fed will eventually have to raise rates. They know this and already planted the idea of 2022 rate hikes. These rate hikes would be a year ahead of schedule.
Speeding up the rate hike schedule simultaneously says two things:
#1: The economy is recovering at a sufficient pace to consider raising rates sooner.
#2: Raising rates is a counter to inflation. We have to act sooner than anticipated to stop the threat.
So what does this inflation talk have to do with tech stocks?
Tech stocks are notorious for their high valuations. These stocks receive high valuations because investors believe in the future potential of those companies. Inflation erodes future earnings, making the future of those companies less promising. Investors react to the change by selling off their shares.
But that’s not all. Since inflation results in rate hikes, the cost of debt increases. Many companies fund part of their initiatives through debt.
If you buy a home with a $100,000 mortgage, the interest rate impacts your monthly payment. The difference between a 2% interest rate and a 3% interest rate is $1,000 (excluding compounding).
Consider the difference a single percentage point will have for debt that exceeds $1 billion. Rate hikes cost certain companies millions of dollars because their interest payments increase. Higher expenses hurt a company’s path to profitability.
Tech companies that rely on debt to fund their catalysts will face downward pressure on their stock prices.
Valuations Are At Historic Highs
I touched upon valuations before, but it’s essential to view this deeper. Back in January, the stock market was at its most expensive levels ever. Meanwhile, the NASDAQ and S&P 500 continued marching towards higher valuations.
Stock valuations don’t get to march higher and higher to infinity. At some point, something has to give. It’s the reason I’m currently prioritizing valuations over mind-boggling revenue growth.
Tech stocks tend to carry the highest valuations, which gives them the lowest margin of safety. In other words, if the market goes haywire, these stocks may fall the hardest.
Even if these stocks produce robust earnings data, investors will question valuations. Would you pay $10,000 for a concert ticket to see your favorite singer? I don’t care who’s singing. I’m not paying $10,000 for a concert ticket.
Tech stocks, especially the high growth segment, present this scenario. You’re paying a high price for something that may or may not work as you hoped. Solid growth numbers aren’t enough. They must be exceptional.
A highly valued company that regularly posts 40% YOY growth and then suddenly reports 30% YOY growth will tumble. Most companies would love 30% YOY growth, but that growth rate is insufficient to justify the high valuation for certain companies.
Tech stocks should present a high-risk, high reward scenario. However, higher valuations combined with economic concerns have amplified the risk and minimized the reward.