Taking stock - crash or correction for the tech sector?

A Wall Street Journal article attested earlier this month that tech’s dominance of the financial markets is coming to an end, with stocks experiencing their biggest rout in a decade.

Tech start-ups and scale-ups are cutting jobs left, right and center, and as of this week, S&P’s IT Sector index had dropped by 12.61% year-on-year.

So just what is going on here? Is this a blip, a correction or a big, old-fashioned crash? Opinions are mixed.

Mark Peter Davis is Founder and Managing Partner at venture capital (VC) and start-up service provider Interplay. He points out that, in macro-economic terms, the markets have until recently experienced their “longest bull run in history”.

As a result, it was inevitable that “something was going to happen”, particularly in the wake of the huge pandemic-related stimulus package introduced by the US Federal Reserve to boost the economy. When combined with unprecedentedly low interest rates, this scenario encouraged both consumers and investors to spend, and for young companies to benefit from what appeared to be “an infinite pile of money”.

The cracks started to show, however, when the Fed began raising interest rates, followed by quantitative tightening, to try to dampen down the resultant inflation, which was worsened by global supply chain difficulties and the impact of the war in Ukraine.

Understanding the tech bubble

As stock markets fell in value, the denominator effect kicked in. In other words, many large institutional investors found their portfolios were too focused on VCs and so took action to rebalance them. But the resultant liquidity crunch has hit start-ups and scale-ups hard, particularly in the tech sector.

Another important factor here, says Dr Richard Smith, a risk expert and Founder and CEO of investment app provider RiskSmith, was that at the same time as equity values started falling, bonds began earning interest again:

A lot of what was driving the tech bubble was that people had no real choice on where to invest their money as you couldn’t earn interest anywhere…But there were also a lot of crazy, unrealistic expectations created in 2021 that led to this situation. Companies thought there was free money out there and so tried to get valuations as high as they could, create SPACs, all that stuff.

So we’ve now got to reset our expectations of what is reasonable because that wasn’t. In 2021, it was the last gasp of a bubble that’s been building for 20 years – especially since 2008 when it was all stimulus, stimulus, stimulus.

But beyond the fact that tech stocks were more highly inflated than those in other sectors, a further reason why they are being so badly hit now is due to “increasing uncertainty about the future”. As Smith points out:

It’s becoming harder to predict as there are more variants, but tech stocks are all about future cash flows, so they’re under a lot of pressure.

How the pressure is manifesting itself

One way this pressure is making itself felt is that start-ups are now having to actively demonstrate they can return value to their investors. Raj Shah, North America Industry Lead for Telecom, Media and Entertainment and Technology at digital consultancy Publicis Sapient, explains:

Companies that may have had five to seven year horizons have seen their runways shrink to a year or less. This resulting pressure has meant cost cuts, hiring freezes, and the shutdown of companies, which in turn has led to some panic selling of tech stocks across the spectrum. Consider this a culling of those companies with weak plans for returns or profitability.

While the situation may likewise be hitting the value of established, ‘safe harbor’ companies, such as Microsoft, Google and Apple, Shah believes their income and balance sheets remain strong. As a result, although they could continue to be hit by short-term supply chain issues, which hamper product development and sales, they “will weather the storm and likely emerge stronger”, he suggests.

In fact, Shah describes tech investment as actually having remained “relatively strong” overall, even if some investors have started turning towards sectors, such as healthcare and food, which tend to weather recessions better than others.

This is because, unlike the financial crisis of 2008, investment capital is still available and VC funds continue to be interested in tech sub-sectors likely to generate long-term returns. These include battery and energy technologies, robotics and some AI-based fields, including talent management and supply chain.

The big difference today, says Shah, is that investment managers are no longer chasing start-ups. Instead start-ups are “now having to prove their merit for investment.”

An intentional contraction

Ultimately what this all means, believes Davis, is that financial markets are experiencing what he describes as a “major contraction” that is “intentional by the Fed” in order to ensure the health of the global economy:

The US and global economy has been in seventh gear for years – they’ve been overheating. But a return to normal interest rates has led to a downshift, in which markets have been recalibrated into fifth gear. I wouldn’t say they’re crashing – they’re just going back towards more normal levels.

Unlike the 2008 financial crisis though when “we blew a piston in the engine, it broke and we didn’t know if it would work any more”, this time Davis does not believe “the sky is falling in” as he believes the shift is taking place in a “more controlled way”. He explains:

The Fed is ripping the bandaid off and into the long-term, it’s healthy, but in the short-term it’ll be very painful. Moving from seventh to fifth gear means the entire supply chain has to recalibrate and resize and there’ll be a ripple effect as everything else recalibrates too. How long that will take I don’t know, but it usually takes between five and 10 years for the escalator to go up and between 12 and 24 months for it to come down.

More than a correction

As for Smith, he believes that the situation is way “more than a correction”:

You could already call it a ‘crash’, especially if you want to talk about cryptocurrencies, and I don’t think the worst of it is over yet. What’s guiding my expectations is that this contraction is about halfway done and I’d expect a similar experience over the next 12 to 18 months - I don’t think we’ll really see a bull market until late 2023. So if you’re a tech company, you have to be planning for a different market for the next 18 months to ensure you can survive.

A positive for investors and tech companies with strong balance sheets, however, is that acquisitions are likely to become more attractive price-wise as valuations dip, points out Shah. Moreover, tech salaries that have soared over recent years due to labour shortages “may plateau – albeit still at high levels” as start-ups find capital harder to raise, rein in hiring and cut surplus, making talent more readily available.

Into the long-term, meanwhile, Smith believes that the future remains “bright” for the tech sector:

While tech companies with financially-engineered valuations will go out of business, those that can create real value for customers and investors will succeed. We may be in a tech winter right now, but my best guess is it’ll last for another 12 to 18 months or so. That doesn’t mean there won’t be strong rallies, but it’s a time for sobriety and patience and focusing on core competencies and real value creation.

My take

While market corrections are always uncomfortable and painful, I agree with Davis when he says:

A silver lining of recessionary periods is that markets are always stronger afterwards.