Tech stocks, especially the “super cap” tech stocks like Microsoft, Apple, and Alphabet, have held the limelight of the market for the better part of two decades. There have been plenty of good reasons for this dynamic due to a few major underlying trends within the US and global economy. Borrowing costs have generally gone down globally, consumer financial health has improved, and a shift from brick and mortar to online consumption has overhauled the retail power structure.
There’s little doubt that companies like Apple and Microsoft will continue to have a vice grip on consumer behavior for the foreseeable future. I don’t foresee people shunning their smart devices anytime soon! The tides appear to be turning the most for tech within the broader tech complex. Examples of these companies are those that have seen their price-to-earnings ratios balloon to the 100s, while the average company in the S&P 500 has a P/E of 19.2. The market appears to be looking at these companies in a new light for various reasons. Here are a few reasons we believe tech stocks may face some unique challenges in the future.
Regulatory Scrutiny on Corporate Acquisitions
The idea has been brewing for years now, but regulators are beginning to fully threaten the wave of corporate mergers and acquisitions (M&A) that have been occurring in the tech industry. Nvidia was forced to drop its bid for ARM under intense regulatory scrutiny. At the same time, Lockheed Martin terminated a deal to acquire Aerojet Rocketdyne as they received similar pressure from regulators to justify the deal. Further, the Department of Justice, alongside the Federal Trade Commission, is seeking to rewrite the merger guidelines for businesses in an effort to take a more forceful approach to antitrust enforcement. Now that Microsoft has made a bid for Activision and Amazon is seeking to acquire MGM Studios, the microscope is on these companies and the actions of the regulators to paint a picture of what can be expected for M&A going forward.
This is impactful to tech is because M&A has been a significant driver of growth within the industry over the past two decades. Large companies have swallowed up smaller companies at increasingly larger and larger valuations. Speculation on who the next takeover target is for “XYZ” company can significantly boost a target company’s valuation on nothing more than a hunch. If the regulatory environment is such that these deals become less frequent, fewer speculators will be betting on acquisitions to increase a company’s valuation.
Interest Rates Impacting Valuations
It’s not just the prospect of rising interest rates, either. Inflation headwinds can dampen consumer spending habits if wages don’t keep up, and economic growth is expected to stall due to fewer stimulus dollars getting pushed back into the economy. Rising rates traditionally correlate negatively with tech stock valuations. And because much of the recent increase in tech stock prices were more a function of valuations increasing and less related to the company’s business becoming more profitable, you now have an environment where tech stock prices can become unstable as valuations are revisited due to a higher interest rate environment.
Advertising and Privacy
As Apple made changes to their app ecosystem related to privacy and tracking user data, the thought was these changes would eventually become a headwind for advertisers on their platform. We’re now seeing these privacy restrictions impact advertisers’ profitability as Meta (previously named Facebook) suggested they could lose $10 billion in sales due to Apple’s privacy adjustments.
More recently, Alphabet (Google) also announced its intent to restrict advertisers’ access to user data to align itself more closely with their users’ privacy demands. When you have the two largest mobile platforms on the planet saying they are going to gut targeted advertising on their platforms, I think it’s a fair assumption to suggest this will be impactful to companies who rely on user data as a profit source. Many tech companies rely on targeted advertising to promote their business or gain greater detail on their user base. These privacy changes by Apple and Alphabet are likely to act as headwinds to advertising profitability.
While there is no shortage of headwinds for tech in general, we have also seen plenty of instances where the tech phoenix has risen from the ashes despite the gloomiest of outlooks. We’re not of the mindset that tech is dead or won’t play a vital role in the market’s future. Instead, we believe now more than ever it’s essential to approach investing in this market through a balanced and diversified manner. In 2021 risk-takers were rewarded through increased valuations during a period of cheap money and excess stimulus. The story has changed in 2022, and investors should make adjustments as well.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All investing involves risk including loss of principal. No strategy assures success or protects against loss. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.