Let’s be honest: We’re all looking to buy the dip in tech stocks.
Sure, the current selloff scares a lot of us. But deep down, we all know this tech stock plunge will turn into a generational buying opportunity.
Why? Because tech is at the center of society’s undeniable future.
Tech platforms are transforming the way we travel, work, play, eat, and more. Technology is changing everything. That has been and will remain true. So, in the long run, tech companies will absorb all the world’s economic demand, grow their revenues and earnings the fastest, and see the biggest stock price gains.
It’s that simple.
That’s why buying the dip in the current tech selloff isn’t a matter of “if.” Rather, it’s a matter of “when.”
And thanks to what appears to be a critical turning point for tech stocks in 2022, the “when” could be right now.
Treasury Yields Are Topping Out
The most crucial factor driving tech stocks in 2022 has been the 10-year Treasury yield.
This is the yield investors earn for buying 10-year notes issued by the U.S. Treasury. It’s the rate of annual return investors can expect when buying a risk-free bond from the U.S. government. And it’s widely considered the U.S. economy’s “risk-free rate.”
A lot of things depend on the 10-year yield. And as it relates to tech stocks, the 10-year has two major impacts:
- Valuation. Traditional stock valuation models rely on calculating the net present value of a firm’s future cash flows. The discount rate in that sum is the risk-free rate, or the 10-year Treasury yield. The higher the risk-free rate, the lower the net present value of future cash flows and the lower the valuation. Therefore, across all stocks, a higher 10-year means a lower present valuation. This is especially true for tech stocks. All their value is tied up in future cash flows, not current assets.
- Cost of growth. A lot of tech companies are early-stage disruptors in growth mode focused on capturing market share and not instant profitability. As such, they rely on external capital to fund their growth. When interest rates are low, that excess capital is abundant and cheap. When interest rates are high, that excess capital is scarce and expensive.
To that end, tech stocks are acutely sensitive to changes in the 10-year. Typically, a lower yield is better for tech stocks because it enhances growth prospects and boosts valuation. Meanwhile, a higher yield is worse for tech stocks because it dilutes growth prospects and compresses valuation.
This relationship has been exceptionally strong in 2022. As you can see in the chart below, the sharp ascent in the 10-year throughout this year has directly led to a strong drop in tech stocks. So, if you’re looking to buy the dip in tech stocks, you want to wait for the 10-year to top out.
That may be happening as we speak.
Look at that chart again. The 10-year yield formed a near-term top in early May above 3.1%. Ever since, yields have been moving lower. And uncoincidentally, tech stocks have been moving higher.
This could just be a head fake… but we don’t think so.
We think it’s the beginning of a massive breakdown in Treasury yields — and a massive breakout in tech stocks!
The Math Says Yields Go Lower
As many of you know, I’m a numbers guy. When it comes to picking stocks — and, really, making any decision in life — I trust the numbers.
So… what are they saying about Treasury yields?
They’ve topped out.
One of the financial world’s most widely followed metrics is the spread between the 10-year and 3-month Treasury yields. We’ll refer to this as the “10-3 spread” from here on out.
Since 1980, the 10-3 has historically averaged about 165 basis points. Currently, we’re right in line with that average, with a 10-3 spread of 169 basis points.
However, the 10-3 tends to move in cycles. That is, it tends to expand when the Federal Reserve is cutting rates. And it tends to compress when the Fed is hiking rates. This is because Fed rate cuts juice the economy, thereby improving the economic outlook, resulting in a steeper yield curve. Fed rate hikes curtail the economy, thereby deteriorating the economic outlook, resulting in a flatter yield curve.
The 10-3 spread tends to compress on a 1:1 basis with rate hikes. That is, every 25-basis-point rate hike tends to be met with a 25-basis-point compression in the 10-3 spread.
This happened during the 2017-18 rate-hike cycle, wherein eight rate hikes caused a ~200-basis-point compression in the 10-3. It also happened in 2004-06, when rate hikes pushed the 10-3 spread down by ~400 basis points. In 1999-2000, seven rate hikes drove the spread down ~125 basis points). In 1994-95, 12 rate hikes pushed the spread down by ~300 basis points. And we saw this again in 1988-89, when 12 rate hikes sent the spread down ~250 basis points).
This pattern is clear. Over the past 40 years, it has no exceptions. Therefore, we fully expect it to persist this time around.
Indeed, we’re already seeing it play out.
Big Rally Ahead for Tech Stocks?
The 10-3 spread peaked earlier this year at 2.3%. We’re already down to about 1.7% at last check. That’s down about 60 basis points on three rate hikes — very consistent with the historical pattern.
We know that the Fed will hike 50 basis points in both June and July. That would mark seven 25-basis-point rate hikes this year. Many believe it will also hike 50 basis points in September, followed by 25-basis-point hikes in November and December. Therefore, it seems likely that the Fed hikes rates somewhere between seven and 11 times this year.
Now, let’s do some math.
At seven rate hikes in 2022:
- The effective Fed funds rate would be 1.75%, meaning 0.25% for each rate hike.
- The 3-month yield tends to track to the effective Fed funds rate 1:1, so it would approximate to 1.75% as well.
- The 10-3 spread would compress by: number of rate hikes (seven) x historical compression per rate hike (0.25%) = 1.75%.
- New 10-3 spread = peak spread (2.3%) – compression (1.75%) = 0.55%
- 10-year yield = 3-month yield (1.75%) + 10-3 spread (0.55%) = 2.3%.
- That’s substantially below where the 10-year is today (2.95%).
At 11 rate hikes in 2022:
- The effective Fed funds rate would be 2.75%, meaning 0.25% for each rate hike.
- The 3-month would approximate to 2.75%, too.
- The 10-3 spread would compress by: number of rate hikes (11) x historical compression per rate hike (0.25%) = 1.75%.
- New 10-3 spread = peak spread (2.3%) – compression (2.75%) = -0.45%, which we’ll approximate to 0% to be conservative.
- 10-year yield = 3-month yield (2.75%) + 10-3 spread (0%) = 2.75%.
- That’s slightly below where the 10-year is today (2.95%).
In other words, so long as the Fed stays within the guardrails of seven to 11 rate hikes this year (which we see as a greater than 90% chance of happening), the math strongly suggests the 10-year yield will finish the year between 2.3% and 2.75%.
We’re at 2.95% today, so we’re making the call that the 10-year has topped out for 2022.
If so, then that means tech stocks are ready to rally as their biggest headwind of 2022 turns into a major tailwind!
The Final Word on Tech Stocks
Buying the dip in tech stocks isn’t a matter of “if.” It’s a matter of “when.”
What March and May’s face-melting countertrend rallies in tech stocks proved was that these stocks are just waiting to soar. They’re beaten-up, undervalued and oversold. And they’re just waiting for one good catalyst to come along to send them surging 2X, 3X, even 5X higher in a hurry.
That good catalyst may finally be showing up to the party.
All year long, the biggest headwind for tech stocks has been the sharp ascent in the 10-year yield. That climb looks ready to turn into a drop. If so, the tech sector’s biggest headwind is about to turn into a big-time tailwind. Amid that transition, all this pent-up “buy-the-dip” demand in tech stocks could get unleashed in a furious way.
If it does, we’re talking about potential 5X-plus rallies in some tech stocks over the next six months alone.
Make no mistake. This could be one of the best money-making opportunities the stock market could present in our lifetimes.
On the date of publication, Luke Lango did not have (either directly or indirectly) any positions in the securities mentioned in this article.