The What & Why of Recent Tech Stocks Volatility
{P.S. Our CIO Rocks}
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They say you should learn something new every single day. Which bodes two questions. One, who are “they”? And two, are you doing your best to continually better yourself by learning something new? This is a mantra I certainly do my best to subscribe to. Living with three kids under the age of ten, this is easy to do. For instance, the other day I learned that pineapples don’t grow on trees! Who knew?
Now, not all my education comes from pre-teens. You see I love our CIO, Mike Horwath. He always helps me remember the adage, “if you are the smartest person in the room, you are in the wrong room.” He is a wealth of knowledge (pun intended).
The other day we were discussing the latest selloff in growth stocks and particularly the tech sector, which is off around 11% as of writing this in 2022 alone. I was a little perplexed I have to admit, as my wife is still personally responsible for Amazon’s earnings since there seems to be a package at my door daily.
That said, after a spirited discussion the light bulb finally went off. I’ll spare you all the industry jargon and do my best to describe what is going on in the simplest of terms.
Tech Stocks 101
For starters, it is important to recognize where we’ve been as it pertains to the tech stocks. For the better part of a decade, the tech industry has been a behemoth. If you bought Apple or Amazon a decade ago you certainly understand. With so much innovation tied to technology, it isn’t much of a surprise that it has been one of the best-performing sectors. If you think about some of the fastest-growing industries and companies, many are tied to social media, electric vehicles, cloud services, semiconductors, and artificial intelligence. All roads lead back to a central theme of technological innovation.
The Rise in Technology
The other important piece to the rise in technology stocks (and growth-oriented stocks in general) is the market environment. First, let me just say, that while companies like Amazon and Tesla don’t fall technically in the technology sector, I’m looking at them in the same way. But why has the general economic environment been favorable to growth stocks like those in the technology sector? To understand this, we must address the simple point of what the true value of a company/stock should be.
In theory, a stock’s price should be the present value of all future cash flows (earnings). Pretty simple, right? Over the long term, the companies generating the most earnings are going to be some of the most successful. To get the present value of those predicted earnings, one must discount them using some sort of interest rate based on current rates. So why does this matter and how did it favor the technology sector:
- A general characteristic of many technology and growth companies is that they’re not very profitable today. Much of the excitement is the fact that their growth should lead to substantially higher earnings longer into the future.
- Investors are willing to pay higher prices for these companies based on current earnings for that expectation of higher earnings in the future.
- When investors calculate the present value of those future earnings, the fact that rates have been so low has given them a boost. As interest rates rise, you must discount at higher interest rates which then makes today’s value lower.
If the market environment has been so conducive to these types of companies, what is going on that changes some of that dynamic?
So, what has changed with tech stocks?
This is the question or lesson of the day. What fundamentally has changed to cause such a headwind for tech stocks? To answer that let’s follow a series of events. We all know inflation has reared its ugly head recently. Now inflation isn’t necessarily a bad thing, but it is a thing the Fed tries to keep at a reasonable rate, say 2-3%. When the Fed sees inflation hit 7%, as it did in December, they go to their tool bag of tricks. The primary arrow in their quiver is generally to start increasing short-term interest rates. How does this help you may wonder? By increasing interest rates, it makes the cost of debt higher, tends to slow economic activity, and promotes savings.
The impact of this trickles through the economy. Many companies will not be able to afford higher debt levels (or not be as interested) to reinvest in their businesses. Consumers may decide to save more rather than borrowing to buy a car or new home. Not only do we see an economic effect, but also in the way the stock market favors and values different types of companies.
Net Effect
As I mentioned above, interest rates are one of the pieces to how many investors value companies. With technology and growth-oriented companies more sensitive to interest rates, there has been some market repricing that has taken place. I like to think of this less as investors running away from technology companies and more as a reset of expectations. The challenge is that the U.S. stock indexes have become top-heavy with big technology firms and thus the impact is felt heavier than it used to be. Take a look at the top 10 largest U.S. companies and see how many fall into this category.
Final thoughts on tech stock volatility
Here at Diversified, we are not really concerned about a major recession. Rather, we see this as a time when investors are repricing and rotating their holdings. Technology is here to stay and we’re going to clearly have it as a piece to our portfolios, but this is a friendly reminder that diversification and perspective matter. It may mean further choppiness ahead as the markets get back on solid footing. We highly recommend three things in this environment:
- Don’t panic
- Stick to your investment philosophy
- Work with a professional like us here at Diversified as we are making a lot of these changes already. Oh and I’m proud to say we got the smartest guy in the room!
Hope you enjoyed this blog and learned something new. And yes if you learned a few things new it counts for a couple of extra days!
Stay wealthy, healthy, and happy.
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