After a decade of outperformance, tech stocks saw one of their worst years performance-wise, mainly due to deteriorating economic conditions, tighter monetary policy, and a rush of capital into sectors such as energy, industrials, or materials.
Based on current valuations, tech stocks were certainly crushed this year and as prices eased significantly from all-time highs, people are beginning to ask whether conditions can change for the better heading into 2023. For now, the picture continues to be uncertain, and investors are likely to monitor several important factors.
High interest rates not favoring long duration assets
In an environment where short and long-term interest rates are low, tech stocks are thriving. That is no longer the case this year, given central banks around the world were forced to tighten monetary policy in order to fight inflation. The US Federal Reserve raised rates to 3.75%-4% and is expected to continue with a few more moves, clouding the outlook for big tech.
Stocks of Facebook, Netflix, Google, and Microsoft failed to continue the rally that started in March 2020. According to experts at the major retail brokerage easymarkets, markets have been discounting higher rates this year, which explains why tech and discretionary stocks are the most hit.
A company is worth no more than the profit it produces. Also, stock market valuations price in forward-looking revenues/profits, which have to be discounted based on current interest rates. Tech stocks benefit from low interest rates not just due to this matter, but also because they can borrow cheaply and fund their activity, as well as buyback operations.
Profit margins compressing
Another important aspect traders should consider is that the markets have not yet priced in an earnings recession. In fact, EPS figures on aggregate for S&P 500 companies continued to expand by approximately 5% this year. Compared to a 20% growth in 2021, earnings have moderated substantially, yet tech stocks might take another hit in case profit margins begin to post negative figures.
Investors want to gain exposure to companies that are cash-flow generative and don’t need to rely on issuing a lot of debt to function. Stocks posting disappointing returns have been hit hard during the last two quarters, suggesting market participants are once again taking fundamentals seriously.
Mean-reversion in overvalued companies
Markets were dominated by exuberance, leading to overvalued stocks. Narratives like TINA (“There Is No Alternative” to stocks) incentivized traders to continue buying shares, even if it was unlikely that the underlying companies could end up realizing the projected profits.
Reversions to the mean happen when cool-minded thinking kicks back in, leading to a bearish move that can overextend on the downside. With no fundamental support and interest rates projected to remain elevated at least until inflation moderates, tech stock valuations can continue to disappoint in 2023.
Optimism is tied to a monetary policy pivot, but statistics show stocks are falling hard first, before the effects of loose financial conditions make their way into the economy.