The problem with knowing when the ‘tech rout’ will end is that it is not obvious exactly what is causing it. In part, it is the fault of rising interest rates. However, there is also the wider advertising slowdown to consider and the sharp increase in costs during the pandemic. Unpicking the relative strength of each of these factors is an imperfect science.
For investors who have been living under a rock, the last 12 months has seen the biggest fall for technology companies since the dot com bubble. Meta Platforms (US:META) is down 73 per cent, Alphabet (US:GOOGL) 42 per cent, Microsoft (US:MSFT) 35 per cent and Amazon (US:AMZN) 46 per cent. Chip designer Nvidia (US:NVDA) is also down by half and Tesla (US:TSLA) has fallen 47 per cent. The only major company that has shown resilience is Apple (US:AAPL), which has fallen just 8 per cent.
All these companies, in some shape or form, promise to define our future. Meta wants to connect us in a virtual world, Google is pioneering in AI and Tesla envisions everyone driving in automated electric vehicles. At the beginning of 2021, the market had bought into all these visions. Tesla was trading at a PE ratio of 315, Meta (at the time known as Facebook) at 27 and Google’s was at 30. At these prices, investors were expecting substantial future growth.
Interest rates matter a lot
Since then, the 10-Year Treasury yield has risen above 4 per cent. This future growth started being discounted at a higher rate, which has compressed valuations across the whole US stock market. However, it has been worse for those tech companies that promised cash flows way into the future.
To get a feel for the impact of rate rises we can compare the price of Cathy Wood’s Ark Innovation ETF (US:ARKK) to the S&P 500 Value index. Ark includes the stocks of some of the most speculative companies in the world. Many of them are yet to make a profit. It includes Tesla and Nvidia in its holdings, as well as online game platform popular with children Roblox (US:RBLX) and 3D printing software company Materialise (US:MTLS).
Like big tech, all these companies promise to change our future. Investors purchased them on this basis. The beliefs we will be 3D printing our food, putting on a virtual reality headsets en masse, and building a house in Roblox are all still fanciful as it stands. This makes them hugely sensitive to interest rate rises.
This sensitivity can be seen when Ark Innovation is contrasted with the S&P 500 Value index, which includes some of the most stable cash-generative businesses in the US. These are the companies least sensitive to rate rises. Since September last year, Ark’s price has fallen 71 per cent. The S&P 500 Value has dropped 7 per cent.
Where does that leave big tech? Some are arguably now value stocks themselves because they generate huge amount of cash from selling advertising on their platforms. Most have reached market saturation point, and advertising is just a function of wider economic activity. However, as we can see with the strong performance from the S&P 500 Value Index, it is not the wider economic downturn which is pushing down Meta, Amazon and Google’s market cap.
The drop in the price of Ark suggests this sell-off is mainly driven by interest rate rises and the devaluation of the most speculative parts of the big tech businesses. Therefore, as soon as the rates start to fall, or the Fed ‘pivots’, the valuations of these tech businesses should start heading upwards. And at some point, the Fed will pivot.
Deflation can already be seen in parts of the economy as mortgage rates and energy price rises burn through people’s pandemic savings. The cost of shipping a 40ft container from China to the US West Coast has dropped 84 per cent since the start of April. Meanwhile chip maker Qualcomm (US:QCOM) has warned of sluggish phone sales and built-up inventory. It now expects handset volumes to decline by low double digits. Chip shortages that drove early inflation in 2021 are now reversing, with the prospect of oversupply emerging. A recession is coming. This is theoretically good news for Meta, Google and Microsoft, which have seen their share price disproportionately hit by rising rates.
A narrative shift
The only thing that would make these devaluations permanent is if the business models of these companies have broken. These businesses are burning through cash on capital expenditure. Meta Platforms has jumped from $15bn in capex 2019 to an expected $31bn this year as it piles money in virtual reality and AI. Amazon’s capex has risen from $16.9bn to $61bn over the same period, as it brought more warehouse space and built server capacity for cloud computing.
This sort of spending is fine for investors if they expect returns on equity (ROE) to stay around the mid 20 per cent level, where it has historically been. The issue comes when investors lose faith in the futures these companies promise. Meta Platforms chief executive Mark Zuckerburg has appealed to investors to take a long-term view when it comes to virtual reality and AI investing. “I appreciate the patience and think that those who are patient and invest with us will end being rewarded,” he said.
In a recent open letter, tech fund Altimeter Capital's chief executive Brad Gerstner asked Meta to cut capex and reduce headcount. It blamed the company for reckless spending after its core business “hit a wall” last autumn, with subscriber growth across its social media platforms stalling. Gerstner also pointed an accusing figure at headcount, which grew from 25,000 to 85,000 in last four years. “We would encourage the company to move aggressively and cut at least 20 per cent of employees,” he wrote.
Confidence in Microsoft and Amazon's cloud computing projects is also slipping. Cloud computing has long been touted as a main growth driver, but each company's cloud unit saw revenue fall below analyst expectations in third quarter earnings. Microsoft is now expecting growth to slow next quarter as well. “We expect Azure [its cloud product] revenue growth to be sequentially lower by roughly five points on a constant currency basis,” said Microsoft chief financial officer Amy Hood.
The case can be made that these companies simply don’t have the future they did. The combination of this pessimism around their business models and rising bond yields is what has driven this market rout, rather than the cyclical nature of the economy. Advertising spending crashed in 2008 and bounced back. It is crashing again and will bounce back again.
In terms of rates, while they are clearly having a huge impact on valuations, they won't continue to rise forever. So the question of how valid business models are remains crucial.
Answers will vary between companies. Amazon is betting big on cloud computing, alongside Alphabet and Microsoft. Picking the winner among this trio is tricky, and there is a concern they will compete away profit margins in the same way telecoms has. But almost all software will be run on other people's servers. The market is obviously there, and still growing.
Meanwhile, Alphabet, Microsoft and Meta are all spending huge amounts on AI. AI is a technology that has promised to change the world but the specifics of that remain vague. One way is through search: AI could revolutionise search engines, providing more complete answers to question by scrapping all know information on the internet. It Google could crack it, AI would cement its position as the gatekeeper of the internet. Alternatively, if Microsoft gets there first, people might switch their allegiances to Bing.
Likely, the most important AI use cases remain beyond the realms of our imaginations. Based on valuations, markets have clearly lost faith it will be Alphabet or Facebook that delivers it. The narrative has shifted to present day projects, and present day prospects. Whether it is based on good evidence isn't yet clear.
