The reasons for the fall in technology stocks are well known: firstly, the current monetary tightening and the accompanying rise in interest rates, which is weighing heavily on stock market valuations. This is especially true since the sector’s valuations have been greatly overvalued since the covid crisis started. Increasing uncertainty about the trajectory of growth should also weigh on earnings prospects, as the sector is highly dependent on discretionary consumer spending.
Spending in a post-covid period had been normalising, but may now be well down. “Consumers were staying at home and spending their money from the couch,” said David Older, head of equities at Carmignac, an investment firm with €41.7bn in assets under management. What was just a ‘normalisation’ could, with the deteriorating economic situation, become a lasting structural deterioration in the sector.s prospects.
$5trn market capitalisation lost
The nearly 20% fall in the Nasdaq since the beginning of the year is equivalent to a loss of roughly $5trn in market capitalisation. It is also a sign that investors’ risk aversion has risen.
For professionals, it is obvious that the Nasdaq has fully entered a bear market. This has not been seen since the financial crisis of 2008, except for a few jolts that were contained and had no effect on the bullish trend here and there.
The question is how far prices can fall and for how long.
At the moment, the markets are fragile and any bad news or sign of weakness is violently punished. And even the stars are suffering. Older cited Alphabet (Google’s parent company, weighed down by YouTube’s poor results), Meta (which owns Facebook and Instagram) and Netflix. He questioned the sector’s ability to adapt quickly to the new economic paradigm of permanently higher inflation--moderate inflation is usually thought as a plus for market valuations in general and tech in particular.
He believes that the correction we have seen over the past six to nine months has been about valuation multiples and is now over. “Investors have reduced their exposure to growth sectors such as technology because of high inflation which has led to higher interest rates. This is having a negative effect on valuations, whereas secular growth companies typically trade at a premium. That rate arbitrage is largely over.”
He “remains cautious about technology companies that are not profitable, because in a higher rate environment, investors are not willing to fund growth at the expense of profitability.”
Pockets of opportunity in the current correction
He favours the software sector, which has successfully shifted its business model to subscriptions. It is a model that “offers resilience and pricing power, ideal conditions in a context of rising inflation and slowing growth”. He also favours companies specialising in the provision of infrastructure and software services--such as infrastructure as a service and software as a service--and in cyber security. They are “pockets of opportunity in the current correction environment.”
Older also pointed to the tendency of companies to extrapolate on the results and gains made during the covid crisis. Companies that are now facing ‘normal’ pre-pandemic growth rates. Or even lower. Like Netflix. “Companies whose business was boosted during the covid crisis could take more than a year to return to normal, pre-coronavirus growth rates. The effects of the reopening of economies may have been delayed because of omicron and its real impact is likely to materialise this year. We should probably expect to see an increase in OTT [over-the-top services, meaning media delivered without the involvement of a network operator] churn while the macro economy is likely to be unfavourable.”
The share prices of growth companies in the technology sector incorporate a high level of earnings expectations.
Nicholas Hancock, technology, media and telecoms analyst at Carmignac, said that investors are looking for signs that technology companies have retained sufficient pricing power as inflation accelerates. And he expects high volatility in this half-year earnings season. “In this context of inflationary fears, good results generate limited enthusiasm in the stock market, while bad results are punished. The share prices of growth companies in the technology sector incorporate a high level of earnings expectations. So even with good results, the market reaction can be negative if investors perceive signs of slowing growth.”
Within the technology industry, each sub-sector faces its own issues, Hancock stated. “For companies providing consumer internet services, the main debate is about the strength of the macroeconomic environment and the sustainability of growth for some covid beneficiaries. Investors are focusing on post-covid consumer trends as they try to determine the appropriate growth profile for all the companies that have experienced exceptional growth during the pandemic. In the semiconductor sector, the situation is tricky due to current supply constraints and fears of an upcoming cyclical correction that could hurt demand. This is leading to a situation where the fundamental results of semiconductor companies are being ignored. Investors are anticipating an imminent correction and looking for clues to try and predict it. Finally, the software industry looks strong in this challenging environment.”
Originally published in French by and translated for Delano