What’s behind tech’s weakness … the right way to navigate it … a “quality” orientation is critical for all portfolios today
As I write Monday morning, the pain in the tech sector continues.
Let’s do some quick MBA 101 to make sure we’re all on the same page about what’s driving it.
Theoretically, the value of a stock equals the net present value of a company’s future cash flows plus what the company’s balance sheet says its assets are worth.
To arrive at this “net present value of future cash flows” figure, we use a discount rate. This discount rate typically correlates with prevailing bond yields.
The higher that yields go, the higher the discount rate goes. Mathematically, a higher rate lowers the present value of future cash flows.
Technology growth stocks derive the vast majority of their value from those future cash flows (rather than tons of hard assets, like machinery, on their balance sheets).
So, the higher that yields go, and the higher the discount rate goes, the lower the “net present value” of growth stocks.
And that translates into lower stock prices for technology companies.
So, following these breadcrumbs, it leads us back to bond yields.
***Driving the latest spike in yields were the Fed’s minutes from its December policy meeting released last week
Those minutes sounded more hawkish than some investors anticipated. It has left many believing we’ll see a rate hike as soon as March.
This fear accelerated the rise in the 10-year Treasury yield that started in late summer. The yield has just topped 1.8%, which is a new, pandemic-era high.
As you can see below, the yield has surged 42% since August. Roughly 16% of that surge has happened so far in 2022.
So, higher bond yields typically end up resulting in lower prices for interest-rate sensitive growth stocks. And that’s precisely what’s been happening with tech.
Below, you can see the tech-heavy Nasdaq index saw-toothing up and down beginning in late November. The swings in the circled area are roughly 6%.
Not too easy on the nerves.
***But if similar past selloffs repeat themselves, we could be nearing the bottom
The rate-induced selloff in hyper-expensive technology shares has almost run its course, if past shocks are any guide…
So reckons Morgan Stanley, which compared the carnage in tech that started in December to the five previous instances where rising Treasury yields sparked similar routs.
In those, a basket of loftily valued tech companies tumbled a median 18% from peak to trough — that’s at 15% now in the latest episode.
Morgan Stanley’s analysis was before today’s 2.5% selloff in the Nasdaq (as I write). So, it’s likely we’re very close to that median “tumble” level from the analysis.
Now, even if we’re nearing the bottom of the selling pressure, it’s critical to make sure you’re only holding the best of tech today. This means steer away from “profitless” tech. You want quality, profitable companies with great cash flow.
Our hypergrowth expert, Luke Lango, made this point last week in his Early Stage Investor Daily Notes:
Put extra emphasis on profitable companies.
This is the “show-me-the-money” year. In the face of tightening monetary conditions, investors aren’t willing to take big leaps of faith on companies that promise to make money tomorrow.
Rather, they are only buying stocks of companies that have profits today. We believe profitable stocks will outperform unprofitable stocks over the next few months.
Meanwhile, join the “flight to quality.”
The recent trading action can be characterized as a flight to low-risk, high-quality assets. We suspect this flight to quality will persist.
Focus on companies with strong balance sheets, great cash flows, and high gross profit margins.
***To see why this focus on profits and fundamental strength is important, look at what’s happened to speculative tech stocks
Below, we look at a chart from Morgan Stanley and Bloomberg that begins this past summer.
What you’re seeing is the percentage change in: 1) “expensive software” stocks, 2) “profitless tech” stocks 3) “hedge funds’ crowded stocks” and 4) the S&P 500.
While the S&P has climbed nearing 10% over this period, “profitless tech” has gotten crushed to the tune of a 30% loss.
Back to Luke for how to navigate the risk of further tech weakness as we enter a rising-rate environment:
All in all, we think that in order to protect against near-term market volatility, an emphasis on high-margin, money-making, cash-rich tech companies with relatively low valuations is required over the next few months.
***Looking more broadly, a “flight to quality” is a wise decision for all sectors, not just tech
We all know that the broad market is trading at lofty valuations.
But I’d like to give you an added, simplistic perspective that might drive this home in a different way. This is not intended to create anxiety – it’s merely an angle on the market.
Below, we look at the S&P 500 beginning in 2009. This corresponds with the recovery out of the global financial crisis.
What I’ve done is try to fit a trend line onto the chart. This trend line attempts to trace the median of all the values in the chart so that half the readings are above the trend line, with the other half below.
I’ve circled what’s happened since 2021. In short, market prices have climbed much higher than usual above the long-term trend line.
Now, here’s the punchline…
If the S&P drops from its level (as I write) of 4,586 to its approximate trendline level of 3,800, that would be a loss of roughly 17%.
And if you’re taking an issue with where I’ve drawn the trendline, I’d suggest that technical precision isn’t all that important. As legendary investor Benjamin Graham once said “you don’t have to know a man’s exact weight to know that he’s fat.”
In the same way, whether we’re talking a 17% decline, or 15%, or 12%, the point is the same…
The S&P’s value is far higher than usual above its long-term trendline.
And remember, a 17% mean reversion would only take the S&P’s value back to its long-term trendline level.
Now, look again at the chart…
The last time we saw a meaningful spread between the S&P’s price and its long-term trendline was 2013-2015. After that stretch of relative outperformance, the S&P’s value reverted toward its trendline.
Over roughly 7 months beginning in summer 2015, the S&P fell nearly 15%.
Keep in mind, that fall pushed the S&P’s price below its trendline. Our prospective 17% decline is what could happen if the S&P finds merely support at its trendline – without dipping below it, which would be entirely reasonable.
Bottom-line, the S&P could fall 17% tomorrow and the market’s multi-year growth story wouldn’t even suffer a scratch…though many portfolios would.
***Now, this does not mean panic and sell all your stocks – starting with your technology stocks
The market can keep climbing. That’s not at all unrealistic.
Plus, if you do sell now, how will you know when to get back in? There are countless studies highlighting the near-impossible challenge of correctly timing the market.
And even if we are in for a correction, it’s critical to see the bigger picture.
Returning to quality tech companies such as the ones Luke recommends, those companies are shaping tomorrow’s world. Yes, their stock prices could fall on tough times in the short-term, but over this decade, their dominance will return.
These seasons of weakness are normal, and patience is critical.
Back to Luke:
You can hardly make a move in America without coming into contact with Amazon, Apple, or Microsoft. They are among the most successful businesses in U.S. history. Their soaring stock market values have made many people very rich.
However, these incredible businesses didn’t take over the world in a day, a week, or even a year. It took them years and years to grow from small to dominant.
Only their patient shareholders made the really big money.
Even the greatest businesses need time to “gain weight” and let compound returns work their magic.
As investors, we’d be wise to keep this in mind… be patient with great businesses… think long term… maintain reasonable expectations with our holdings… and snowball our way to wealth.
I’ll add that every stock Luke just mentioned saw major double-digit declines in recent decades. That’s just the name of the game.
Bottom-line, in the short-term, your best defense against volatility is a portfolio containing companies with strong earnings and reliable, growing cash-flows. And especially today, it’s companies that can raise their prices to offset inflation, therein maintaining their margins and earnings.
But the bigger recommendation is to remember the long-term. If you have a lengthy investment timeline, and you’re invested in top-tier stocks such as those Luke recommends, then patience, not panic, is your prescription for today.
Have a good evening,