2022 has been particularly unkind to many technology stocks and the Nasdaq (QQQ) composite as a whole.
There are several culprits, but valuation and inflation are the most severe offenders.
April's consumer price index (CPI) data was released, and the number didn't tell us much. It was lower than March but still above estimates. The CPI rose in April 2022 by 8.3% over the prior year, slightly down from the 8.5% year-over-year ((YoY)) rise in March but above the 8.1% expectation.
Hopefully, this is a sign that inflation has peaked; however, we will have to wait another month to get a clearer picture. This probably means more short-term swings.
But why is inflation so crucial to tech stocks, anyway?
High inflation leads to rising interest rates.
Unlike many value stocks, which are valued on price-to-earnings ((P/E)) ratios or the dividend yield, tech stock valuations often focus on the value of future cash flows. And these are highly dependent on interest rates.
We all know intuitively that a dollar today is worth more than a dollar tomorrow. This is the reason we pay interest to borrow money. The present value of a future cash flow can change drastically based on small changes in the interest rate. Therefore, a tech stock's future cash flow is less valuable when rates rise and the stock's value drops.
The second reason that inflation can be detrimental to tech stocks, and the market in general, is the risk of a recession. When the Federal Reserve raises rates to combat inflation, what it is doing is slowing economic activity. If it slows too much, the country will fall into a recession. The higher the inflation, the more aggressive the FED will become, leading to higher recession risk.
This can crimp revenue, earnings, and cash flow. For example, Visa (V) and Mastercard (MA) could have difficulty during a recession. These companies make a majority of revenue from transaction fees. They can make more money on percentage-based fees as prices rise, but sales suffer when consumer spending drops.
It can be difficult to keep perspective in today's market. The continuous news cycle and inflammatory headlines don't help. Add to this meme stocks, pandemic stocks, SPACs, volatile cryptocurrency, highly speculative companies, and an influx of inexperienced investors, and it is a recipe for volatility. Let's face it, even those who participated in the meme stock frenzy around AMC Entertainment (AMC) and GameStop (GME) know that it is more gambling than investing. This is why I preach two essential strategies for investors:
Speaking of long-term investing, this is a terrific time to step back, take a breath, and put the current market in perspective. To do this, I took some favorite tech stocks and graphed them over the past ten years based on their value on May 10th. This way, all of the short-term noise is removed.
Starting with the Nasdaq composite, we can see that 2021 was an outlier, and long-term investors have done quite well, despite the current correction.
I have graphed some favorites, including Apple (AAPL), Microsoft (MSFT), Nvidia (NVDA), Alphabet (GOOG) (GOOGL), and Amazon (AMZN) below. Apple, Microsoft, and Nvidia are actually up YoY despite being well off their 52-week highs. And long-term shareholders have done well across the board.
By removing the noise, we can see that the long-term results look nothing like the current headlines.
This isn't to say that everything is great right now. It's not. There are many macroeconomic headwinds, and the global economy is still reeling from the pandemic. The market may be heading lower, and investors should be prepared for this.
The high-growth, speculative market is also in trouble. This is evident in the heavy losses taken by Cathie Wood's ARK funds which hold many of these stocks. ARK Innovation (ARKK) and ARK Fintech (ARKF) have been hit particularly hard over the past year, as shown below.
This is a loaded question! Accurately predicting short-term price movements is exceedingly difficult, if not impossible. What we can do is examine trends and company-specific metrics. The Nasdaq Composite is weighted by market cap, so the mega-cap tech giants have an outsized effect on the market. With this in mind, let's take a quick look at the two largest companies on the exchange.
Apple is currently trading about 19% down from its 52-week high and 17% up YoY. Apple posted record sales again in Q2 FY22, with revenue rising 9% YoY.
Sales have risen consistently in recent years, as shown below. This has led to a steady increase in operating profits. The operating margin has also increased, which is a testament to good management and pricing power. Pricing power is critical in an inflationary environment.
Apple is a terrific pick in a down market because of the incredible amount of capital returned to shareholders through buybacks and dividends. The board of directors has authorized another $90 billion for the buyback program, and it shows no signs of slowing.
Stock buybacks offer investors market support and can also leverage earnings. The same investment by Apple will repurchase more shares when the stock price is lower. So, shareholders can rest easy if the stock price drops as their future returns are leveraged. The chart below shows the share repurchases and dividends stacked, with the line representing the decreasing shares outstanding.
Apple also has a vast and dedicated customer base. All of this makes it a terrific long-term investment.
Another excellent pick for long-term investors is Microsoft. Microsoft has several irons in the fire that will continue to heat up in the future. For instance, the company is second only to Amazon in cloud infrastructure market share. The cloud marketplace is expected to flourish for the foreseeable future.
Revenue from Microsoft Azure is growing like a weed. In Q3 FY22, Azure sales rose 46% YoY, while total server products and cloud services revenue were up 29%. Across the board, Microsoft's sales were up 18% YoY.
Margin growth has been a hallmark of Microsoft recently, as shown below. This indicates that the company has pricing power in the market, making it a solid play during high inflation.
There are many challenges for tech stocks in the current environment. The near-term outlook is murky due to uncertainty surrounding inflation, interest rates, geopolitical tensions, and more. Many of the most speculative names have already correctly harshly from 2021 highs.
Still, there are many compelling options for investors with a long-term timeline. Companies that pay dividends, perform buybacks, and have pricing power will likely outperform pure growth plays in the current market. But the market can turn on a dime. A diversified portfolio of companies with lucrative cash flow and secular growth opportunities is a solid, lasting strategy.
This article was written by
Disclosure: I/we have a beneficial long position in the shares of AAPL, MSFT, AMZN, GOOG, MA either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.