It’s been a brutal start to the year for stock market investors.
In fact, the S&P 500 is off to its worst start since 1939, falling over 16% year-to-date. And the once high-flying tech sector is faring even worse.
Even with Friday’s nearly 4% relief rally, the tech-heavy Nasdaq is down more than 25% year-to-date.
Many of the tech names that dominated portfolios and outperformed throughout most of the past decade have seen their shares plummet in 2022. That includes the so-called “FAANG” stocks—Meta (FB), Amazon (AMZN), Apple (AAPL), Netflix (NFLX), and Alphabet (GOOGL).
On average, FAANG shares are down roughly 37% since the start of the year.
Promising tech startups like the retail investing platform Robinhood and the EV maker Rivian have also taken a dive, and work-from-home tech names like Peloton and Zoom, which thrilled investors during the pandemic, have seen mounting losses.
This year’s tech rout has left many market watchers wondering what happened. From recession fears to rising interest rates, it’s obvious that tech stocks have faced a number of headwinds. But should the losses really be this bad?
Some experts argue that the tech sector is now oversold, but the reality is tech companies may still have the odds stacked against them. Here’s why.
A year of macroeconomic headwinds
First and foremost, tech stocks have been hammered by a slew of macroeconomic headwinds—the war in Ukraine, COVID-19 lockdowns in China, snarled supply chains, sky-high inflation, slowing economic growth, and the list goes on.
As Wedbush’s tech analyst Dan Ives wrote in a Friday note, this is “probably the most complex macro backdrop in 100 years.” On top of all that, you have a new “social media world” where every data point can be micro-analyzed by millions, influencing markets in seconds.
This isn’t great news for stocks in general, but tech shares are facing even more headwinds than most. After all, in times of economic pain, throwing money into often highly speculative risk assets isn’t most investors’ idea of a wise move.
Instead, many are looking to “safe-haven assets” to protect their portfolios, as evidenced by the outperformance of value stocks and soaring demand for gold in the first quarter. That’s bad news for the tech sector.
During this week’s brutal stock market sell-off, technology stocks suffered their biggest withdrawals of the year, with investors taking $1.1 billion out of the sector, according to Bank of America strategists led by Michael Hartnett.
It’s a sign of “true capitulation” when investors ditch their most beloved holdings like they have this week, Hartnett and his team said.
“Fear and loathing suggest stocks are prone to an imminent bear market rally, but we do not think ultimate lows have been reached,” the strategists added.
A ‘hard landing’
Investors are also concerned a recession could be on the way as the Federal Reserve raises interest rates to combat inflation. The central bank has been attempting to ensure a “soft landing” for the U.S. economy where inflation is reigned in, but Gross Domestic Product (GDP) growth continues.
But now, even Fed Chair Jerome Powell admits that could be “quite challenging.” As a result, both institutional and retail tech investors have been heading for the exits.
“We believe these stocks are pricing in a ‘hard landing’ with fears abound,” Wedbush’s Dan Ives said.
It’s no wonder why, really. History shows soft landings are exceedingly difficult to pull off.
“Over the past 70 years, there have been 14 episodes of Fed tightening and 11 recessions, with soft landings on only three occasions, or 21% of the time,” Lisa Shalett, Morgan Stanley Wealth Management’s CIO, said in a Monday note.
The Fed is attempting what Shallet describes as an “unprecedented feat,” simultaneously increasing interest rates and reducing the size of its nearly $9 trillion balance sheet.
Throughout the pandemic, the Fed held interest rates near zero and leaned into a somewhat controversial policy called Quantitative Easing (QE), buying billions of dollars of mortgage-backed securities and government bonds each month in order to increase the money supply and drive lending to consumers and businesses.
While QE helped enable one of the most impressive economic recoveries in history from the recent pandemic-induced downturn, it also boosted risk assets like tech stocks.
Now that the “free money” era is over, tech investors are worried that we could be seeing the dot-com bubble all over again. Still, the Street always has its fair share of tech bulls, and many analysts argue that this tech sell-off will come to an end soon—at least for most of the sector.
“In a nutshell, this is not a Dot-com Bubble 2.0, in our opinion. It’s a massive overcorrection in a higher rate environment that will cause a bifurcated tech tape with clear haves and have-nots of tech,” Ives said.
The noted tech bull added that he expects “there will be many tech and EV players that go away or consolidate,” but top names in sectors like cybersecurity and cloud software should continue to outperform in the long run, making this a “generational buying opportunity” for investors willing to take on more risk.
Still, rising rates present unique challenges for tech stocks that are often valued by their ability to grow revenues.
A tech sector repricing as rates rise
Tech stocks are especially sensitive to rising interest rates due, at least in part, to the discounted cash flow (DCF) models that sell-side analysts use to value equities.
In short, DCF models forecast the future cash flows of a company, and then discount those flows back to arrive at a value for what they are worth today.
The key factor used in that discounting process: that’s right, interest rates.
This means that as interest rates go up, the present value of a company’s future earnings goes down. And the larger the expected growth of future earnings, the worse the impact of rising interest rates is on a stock’s valuation.
So high-flying tech companies—which are often valued so highly not because of their profitability, but because of their growth potential—are hit the hardest.
“When rates rise it forces investors to shorten their time horizons and ascribe less value to cash flows further out in the future,” Dave Smith, head of technology investing at Bailard, told Fortune. “Technology tends to have more companies that are eschewing profitability today to invest for future growth. Those stocks have underperformed as rates have jumped higher.”
Smith noted, however, that despite “major missteps” by FAANG companies and ongoing macroeconomic headwinds, sustained outperformance in stock market is typically driven by “organic business growth” and that’s something most FAANG names can still provide.
“It may not be as simple as ‘Buy FAANG’ anymore, but we believe there are a lot of babies being thrown out with the bathwater in the current fear-driven environment. That’s an opportunity for longer-term focused investors,” he said.
This story was originally featured on Fortune.com