Technology investors experienced a tale of "two markets" over the second half of 2021. While mega-cap technology stocks like Apple (AAPL 1.71%), Microsoft (MSFT 2.88%), and Nvidia (NVDA 3.27%)chugged higher along with the market indices, investors in SPAC stocks and small-to-mid cap tech stocks have fallen as much as 80% below their highs.
The more these smaller tech companies fall, the more tempting it might become for investors to flock to these big tech companies, seen as "safe" because they continue to show strength. However, when we dig deeper, there are signs that these big tech stocks could finally run out of steam and fall in 2022.
Nasdaq with a split personality
If you only look at the daily Nasdaq Stock Market levels on TV each day, all seems fine in technology land. The index is within a whisper of all-time highs, which usually would mean that investors are celebrating across the board. However, looking deeper reveals some odd findings.
Just 30% of the roughly 2,500 stocks in the Nasdaq are currently above their 200-day moving average, which is a stock's average closing price over its past 200 trading sessions. This figure is a benchmark that helps indicate whether a stock's price momentum is positive or negative. With so many stocks below that average, it would suggest that the price momentum is negative for most stocks in the Nasdaq.
So how could this be, with the index threatening all-time highs? There is a gap between large technology stocks and smaller tech names. The 100 largest companies in the Nasdaq (called the Nasdaq 100) are up 28% collectively over the past year. These larger companies make up the majority of the broader Nasdaq's weighting, meaning that they can carry the overall index higher even while many smaller stocks move lower.
The inflation problem
We've seen high amounts of inflation this year, with the most recent economic data indicating inflation has high as 6% to 7%. Meanwhile, the Federal Open Market Committee (FOMC) has maintained a Federal Funds interest rate between 0% to 0.25%. This interest rate is the benchmark that banks can borrow at, and this low rate essentially means that borrowing money costs almost nothing. The FOMC set this low rate to support the economy at the beginning of the COVID-19 pandemic.
When inflation begins to rise as it has, it could be a signal that the economy is "running too hot," and policymakers at the FOMC could start to raise interest rates to get inflation back under control.
Rising rates can make money harder to come by in the broader economy (it becomes more expensive to borrow) and tend to hurt the valuations of many growth stocks. This fear is one likely reason why so many growth stocks in the tech sector have traded lower in recent months. Some officials now believe that the target rate could increase to more than 2% by the end of 2023.
Could tech's safe havens be in trouble?
This chart illustrates just how much investors have gravitated to some of the largest stocks in the Nasdaq, including Apple, Tesla, Nvidia, and Microsoft. Nvidia is the "smallest" company in this group, with a market cap of $750 billion; the rest are trillion-dollar companies. These stocks have significantly appreciated and are multi-baggers despite their enormous size over the past three years.
And while these companies are among the largest, most known companies worldwide, the stock price has outrun the actual growth of these businesses; valuations expressed as price-to-sales ratios have doubled (or more) over the same time.
These valuations are now well above their long-term averages, yet the companies are so big that it becomes increasingly harder to grow fast enough to support a higher valuation. Nobody can predict the future, but it seems as though large-cap technology stocks at elevated valuations could be vulnerable to a correction as interest rates rise over the coming quarters.
It could be that the real opportunity is in high-quality tech stocks with smaller market caps, those that investors have been viciously selling across the board in favor of "safe haven" large caps. Sometimes the market zigs when you think it will zag, and 2022 may very well prove to be another example of that.