Is the Party Over for Tech Stocks?

Is the Party Over for Tech Stocks?
Traders work on the floor of the New York Stock Exchange in Manhattan on March 29, 2023. (Brendan McDermid/Reuters)
Fan Yu

At the annual Boys’ Club of New York luncheon on April 4, a 16-year-old guest asked hedge fund manager Chase Coleman what stock he should buy.

It was an innocuous and softball question.

Buy the FAANGs, Coleman said, referring to the acronym that stands for several mega-cap technology stocks Facebook (Meta Platforms), Amazon, Apple, Netflix, and Google (Alphabet).

Wait, is this 2018 again?

Tech stocks suffered a drubbing last year as the Federal Reserve embarked on a series of massive rate increases. The Nasdaq composite index dropped by 33 percent in 2022, its worst performance since 2008.

But the first quarter of this year has seen a complete reversal for technology companies. Tech stocks that were pummeled in 2022 are suddenly big winners. Year-to-date through April 6, shares of Apple are up by 31.7 percent, Netflix is up by 15.1 percent, Alphabet is up by 21.4 percent, and Meta is up by an astounding 73.2 percent. Compared to the S&P 500’s return of 7.3 percent during the same period, these technology giants have far outperformed so far.

A few factors are driving this, and it has little to do with fundamentals.

The first sounds like a tired argument. We know that the tech industry is very interest rate-sensitive. Investors think the Fed is almost done with its tightening monetary policy and that interest rates will flatline from here, or even decline. That’s the old “Fed pivot” argument that we’ve heard for months now.

Another factor is the theme of tech being a safe haven. The market overall has been hit by concerns over the health of the financial sector. Investors were spooked in the aftermath of the collapse of two regional banks, another—Credit Suisse—being subject to a shotgun marriage to UBS, and others including First Republic seeming to remain on life support. Investors have been fleeing financials for the safer balance sheets and robust profitability of tech giants.

The third factor is that tech and innovation have again captured the imagination of consumers. If a certain industry is battered long enough, investors begin to look for silver linings. And that’s the case for tech today.

The mania around artificial intelligence (AI) chatbots such as ChatGPT has reignited growth prospects for cloud computing. The industry-wide cost-cutting and mass layoffs have been viewed as a positive development from the eyes of investors, where profits will become a key focus for tech executives. Structural issues plaguing the sector from the past year or so, such as excess microchip inventory and supply chain problems, are being cleaned up.

In essence, tech has appeared more stable from investors’ lens relative to the general chaos and catastrophes found elsewhere.

The question is, is this phenomenon temporary or will tech continue to shine?

We have to look at fundamentals. Revenue growth is slowing, and that’s the key reason why tech firms have been aggressively laying off staff. When revenues are slowing, expenses must be cut to meet margin expectations. How companies fare going forward will depend on the execution of these expense cuts in conjunction with prudent investments in innovation and future growth areas such as AI.

One headwind for tech is that valuations are again very high. The Nasdaq’s forward price-to-earnings ratio is about 24, which is meaningfully higher than the S&P 500’s 17. Tech companies usually trade at a higher earnings multiple, but this is a giant spread when the historical spread is about 20 percent over the past 10 years.

The technology sector is among the most economically sensitive. Will companies and consumers keep spending, and increase their spending on IT services? Corporations are retrenching, and outside of keeping the status quo, capital expenditures and spending on new tech services are decelerating. And on the consumer side, while wages and employment levels are holding steady for now, it’s difficult to see consumers spending more as opposed to less on streaming services and gadgets.

And lastly, we must circle back to interest rates. High rates are another potential deterrent for continued flows into tech. When money market funds and risk-free treasuries are yielding 4 to 5 percent, are the risk-adjusted returns of a technology stock high enough, considering the precarious state of the global economy?

Fan Yu is an expert in finance and economics and has contributed analyses on China's economy since 2015.
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