This article is for education purposes only, and not to be taken as advice to buy/sell. Please do your own due diligence before committing to any trade/investment.

What is happening to tech stocks?

Ever since the S&P 500 hit an all-time high of 479.98 on January 4, 2022, the general market has suffered a precipitous decline of 8% as of its close at 441.95 on January 29, 2022.

The majority of the drop is led by a correction in technology stocks (The technology-focused Nasdaq index is down 14% since the all-time high it set in November 2021). You might think to yourself: a 14% correction is not too bad considering the Nasdaq is still up a hefty 110% since the covid lows.

However, this decline masks the carnage that some technology stocks have experienced since November 2021. Consider these once uber-popular technology stocks: Peloton, Zoom, Pinterest, and Sea Limited. Since achieving their all-time highs in 2021, these stocks are trading 84%, 68.2%, 70.2%, and 63.4% down their respective all-time highs.

Even more established technology companies like Tesla and Nvidia are not spared either; they are trading 32% and 34.1% down their all-time highs. What is going on? Are technology companies no longer viable companies to invest in? Should we sell tech stocks in 2022?

Some of the aforementioned companies: Zoom, Pinterest, Peloton, are major beneficiaries of Covid-19. This means that these companies enjoyed higher demand for their products and services due to the Covid-19 lockdowns imposed on countries worldwide.

Indeed, Zoom has become a household name as the go-to application to communicate with others online. Pinterest saw more people using its application during the lockdowns as people flock to social media apps to spend time. Peloton enjoyed increased demand for their treadmills as people look to keep up their fitness at home with gyms no longer accessible during those heightened alert periods.

This resulted in an exponential increase in all 3 companies' stock prices as investors bid up these stocks in anticipation of higher demand and sales. Let me illustrate the price rises of these 3 stocks using TradersGPS and how a trader using this system could have profited handsomely in 2020.

Peloton's share price was bided up from the low teens in early 2020 to as high as $170 in early 2021. A trader using TradersGPS to guide him/her in his stock entry would have successfully entered at approximately $28/share and exited close to $90/share. While they might not have achieved the full appreciation potential to $170/share, they would also not see their 3-bagger (from $30 to $90) profits evaporate.

The same can be said for Pinterest, with a positive entry signaled in April 2020 (in the darkest hours of COVID-19). A TradersGPS trader who could ignore all the bearish "noises" and followed the system would have been able to turn his $20/share cost in PINS into a $65/share profitable trade before exiting his/her position successfully with yet another 3-bagger back in early 2021.

Saving the best example for last, Zoom, one of the greatest beneficiaries of COVID-19, gave a positive entry in Jan 2020 at an entry price of $75/share, and the counter "powered" through COVID-19 unscathed. An initial exit was signaled in late July 2020 at an exit price of $250/share or a 3.5-bagger.

Investors and traders alike who partake in these 3 stocks in early 2020 were handsomely rewarded, assuming they took their profits before the "party" ended.

After the release of the Covid-19 vaccines as well as the subsequent lifting of lockdowns, all 3 companies reported a slowdown in their business as people around the world started heading back outdoors.

This led to investors selling off these stocks as they believe that these companies experienced a one-time huge demand surplus due to the pandemic and that these companies are not likely to experience their growth rates.

This is true in the case of Peloton and Pinterest as both companies have since reported lower demand for their products and services (Peloton has seen a decrease in demand for their treadmills while Pinterest has seen a decline in their monthly active users).

Zoom has also experienced a slowdown in their revenue growth partly because they face heavy competition from Microsoft Teams.

Okay, you might think it is fair that these covid-beneficiaries technology stocks got sold off heavily due to a decline in their fundamentals but you might ask: What about Tesla and Nvidia? Aren't these companies still experiencing high demand for their products and services? Why are they being sold off as well?

That is a fair question and the answer to that is simply: It is due to the actions of the Federal Reserve (The Fed).

Watch The Fed

The Federal Reserve is the central bank of the United States that has two key responsibilities: 1) Maintain full employment (as much as possible) and 2) Achieve stable prices.

The Fed achieves these goals by influencing money creation through both fiscal and monetary actions. If the economy is in a recession (think covid-19) with high unemployment, The Fed could look to remedy this issue by making money "cheaper" through the fiscal action of interest rate reduction.

By lowering interest rates, this action will incentivize companies to borrow money to keep their businesses going during these tough times. This would help to stabilize the economy by keeping workers employed. Keeping workers employed and incomes steady would lead to spending on goods and services which would, in turn, generate revenues for companies.

This will create a virtuous cycle that eventually improves the health of the economy. Thus, the act of lowering interest rates by The Fed helps to get an economy back on its feet.

Conversely, when inflation is on the rise or when the economy is doing well, The Fed would look to cool the economy by raising interest rates.

High inflation is undesirable as it results in diminished purchasing power for consumers. You would be able to purchase fewer items today compared to yesterday with high inflation increasing price levels. Higher interest rates reduce consumption as it is more desirable to take advantage of higher interest rates by saving a greater portion of your money. Lower consumption, in turn, reduces demand for goods which reduces price increases.

Hence, The Fed would look to raise interest rates to keep inflation in check per their mandate of maintaining price stability.

Boosting asset prices

Another effect of lowering interest rates is that it helps to boost asset prices. Falling interest rates will increase the attractiveness of other assets (real estate, cryptocurrency, stocks, REITs) compared to bonds as investors will be able to earn a higher return yield on other asset classes compared to just holding a bond.

Indeed, this effect is made more pronounced when The Fed decided to reduce the interest rate to 0% to combat the Covid-19 induced recession. Ask yourself this: Would I rather hold a bond that pays close to 0% interest or would I rather buy assets such as stocks, real estate, and REITs that pay out an average yield of at least 2+% and I get to experience capital appreciation at the same time?

In the chase for yield, investors funneled their money into these higher-yielding asset classes. As such, the above-mentioned assets enjoyed significant price appreciation (average of +50%) since The Fed announced their decision to lower the interest rate to 0%.

Loss-making technology stocks most sensitive to interest rate changes

Technology stocks, especially ones that do not produce cashflows or profits, are the ones most susceptible to changes in interest rates. Their valuations skyrocket when interest rates are low as these companies get to borrow cheap money today to invest in the business which will hopefully lead to substantial growth in revenue, profits, and cash flows in the future.

Investors will bid up these stocks to sometimes ludicrous valuations as long these companies keep growing in accordance with investors' expectations. However, when interest rates increase, these companies' stock prices tend to suffer. Why so?

First, the market is concerned that when borrowings get more expensive, these loss-making technology companies might find it a struggle to raise cash from external sources to continue funding their business expansion. Without the ability to generate free cash flow to sustain their business expansion, these companies will be the first to face financial difficulties when borrowings dry up.

Second, loss-making technology companies are typically valued based on the cash flow that they are expected to generate in the future. Without going into the technicalities, these future cash flows are now worth "less" in a higher interest rate environment vs. a lower interest rate environment. Consequently, this will have a negative impact on their share prices.

As such, the "best time" (this might however be subjective) to buy technology stocks is when The Fed announced that they are lowering interest rates. If u had bought technology stocks when The Fed announced they were reducing interest rates to 0% back in March 2020, you would have done well.

Conversely, the time to trim or sell out your position of technology stocks would be when The Fed announces a rise in interest rates.

In December 2021, The Fed announced that they would look to raise interest rates to combat high inflation.

Inflation in the US is currently at 40-year highs (7% increase in price levels on a year-to-year basis), which is brought about by supply chain bottlenecks caused by Covid-19 as well as significant wealth gain brought about by asset appreciation. This has resulted in a brutal sell-off in technology stocks for the abovementioned reasons.

Unprofitable technology stocks were hit the hardest, (with corrections extending to 70-80% from their peak levels) while profitable technology stocks that had been bided up to ridiculous valuations (Nvidia and Tesla) were not spared too as some savvy investors who had previously gotten in at a low price, now looks to take some money "off the table".

Has the party truly ended for technology stocks?

The Fed has in recent days indicated that they are committed to combating inflation by increasing interest rates to a point where inflation subsides to a more reasonable level of 2%. As such, it is time to review the companies you currently hold in your portfolio.

Companies that produce increasing cashflows and profits, and are expected to continue doing so in the future, should be held while unprofitable companies that are currently in your portfolio should be further scrutinized.

Will these companies continue to generate increasing cash flows in the future or is that sexy story boosted by a one-off black swan event (COVID-19) no longer as appealing?

If you believe in the business prospects of the unprofitable companies you are currently holding and do not mind the volatility in the stock price or the possibility of a sharper drawdown, it is best to add to your position progressively, possibly through a dollar-cost averaging process.

Alternatively, you might look to trim your technology stocks and buy some companies in sectors that do well in an inflationary environment (Oil, financials, etc.).

Do however note that this is not a recommendation to BUY into these stocks. Please do your necessary due diligence.

I would look to add more shares in my favorite technology companies such as Sea Limited. This will be, however, another sharing for another day.

Conclusion

Technology stocks are expected to witness greater headwinds if the Fed decides to raise interest rates more aggressively than what the market expects. Their action is probably going to be dictated by how inflation pans out. If inflation is coming in hotter than expected, then one should expect rates to be hiked more aggressively. That will be negative for technology stocks. On the other hand, if inflation cools, then the Fed can moderate their rate hike pace which will be positive for technology stocks.

For investors holding a portfolio of technology stocks, you need to do a deep dive in your stock counters and decide if they are still the right growth stocks for you. If you continue to believe in their future growth prospects, then engage a dollar-cost average process to buy more of these stocks at a discount.

If you decide that you no longer buy into the growth "narrative" of some of these technology stocks, then sell them and wait for a better opportunity to pounce on better stocks trading at a discount.

As a growth investor, you should be prepared for greater variability/volatility in your portfolio. If you cannot withstand such price movements, then you need to ask yourself if you are really suited to become a growth investor.

Avoid starting off as a growth investor and end up being a value investor because all your growth stocks have more than "halved" in value.

If you enjoyed reading this article and various other investment + personal finance articles, do visit New Academy of Finance. Royston has more than 10 years of buy and sell side experience as a financial analyst. He constantly posts interesting, valuable and actionable articles.

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