We’re experiencing the third market decline of 2022, with tech stocks looking particularly bleak, but what does history say we can expect next? Monday, 16 May 2022
Over the last few weeks, we’ve experienced perhaps the most significant market decline of 2022, and many investors see nothing but a bleak outlook ahead. Tech stocks, in particular, have taken a beating. However, analyzing statistics about drawdowns and looking to history as a guide is helpful in understanding why it’s happening - and why there’s still a great probability for positive returns in 2022.
Hi everyone, Jay Pluimer here with Flourish Insights. As the Director of Investments at Flourish Wealth Management, I take pride in providing our clients, colleagues, and friends with resources and information that can help them make strategic and effective choices regarding their investments. If you’ve been enjoying the show, be sure to subscribe on Apple Podcasts, Spotify, Google Podcasts, or wherever you get your podcasts, so you’ll never miss an episode.
Today, we’re talking about the ongoing Tech Wreck.
In direct contrast to the most recent episode of Flourish Insights about Silver Linings, the stock market has been experiencing another steep decline over the past couple of weeks. This is the third time we’ve experienced a dip in the markets during 2022, and so far it seems to be the most aggressive with a couple of days when the S&P 500 Index dropped by over 2%. Small Cap Growth and Large Cap Technology stocks have been hit even harder and are both in Bear Market territory, meaning they have lost over 20% so far this year. Although it seems like the S&P 500 has done as bad or worse this year, Large Cap Stocks are down around 15% so far this year.
An important statistic during periods when stock prices are dropping is that the market spends about one-third of the time in drawdown. Drawdowns have happened in 33 of the 96 years that we have market data. The drawdown actually has two components – the decline and the recovery. The decline is what we are in right now when the market is falling and nobody seems to know how long it will last or how low the market will go. Bear markets have historically lasted a little over a year with a total loss of around 33%. However, at some point the downward slide ends and the recovery stage begins until the market reaches the pre-downturn level.
It might help to know that the average annual market drop over the past 40 years is 14%. The market is down at some point during the year 100% of the time but has a positive return 75% of the time. That means that our current loss of 15% is pretty average based on market activity over the past 40 years, and that there is still a 75% chance of a positive return in 2022.
But let’s talk about why the market downturn this year feels so bleak. The barrage of negative headlines about inflation, rising food prices, the War in Ukraine, and pain at the pump is a lot to bear for investors. Add in worries about a recession from aggressive Federal Reserve interest rate hikes and it’s not a surprise that investors are questioning why they should stay in the market. (By the way, people definitely should stay in the market or they will lock in the year-to-date losses and miss out on the eventual recovery.)
The hardest hit part of the market so far has been Large Cap Technology and Communications stocks. These companies make up the majority of the NASDAQ Composite which is down about 26% this year. It’s a grim part of the market with 4,700 stocks where 61% of those stocks are down more than 20%, 43% of the stocks are down more than 40%, and 29% are down over 60%. Some of the notable losers this year include companies that had benefited from the COVID economy, including Zoom, Netflix, and Shopify, all of which are down over 70% this year.
There are a few reasons why companies in the NASDAQ Composite are taking the biggest hits from the correction. The first reason is valuation, meaning the stock prices for these companies had been very high after 3 consecutive years of big gains. Stock price estimates are based in part on calculations that use the discount rate, which has been basically zero for the past couple of years but is on the way up with every Fed rate hike. Another hit from higher interest rates is the significant amount of bond debt that these companies have taken on over the past few years, initially issuing record levels of new bond debt to capitalize on the zero interest rate environment but now paying the price for that debt as interest rates spike.
Technology and Communications companies represent over 60% of the NASDAQ Composite compared to 35% of the S&P 500 Index. These companies have been driving stock market returns for the past 10+ years, generating between 20% and 40% of the returns in a given year. For example, the so-called FAANG stocks of Facebook, Apple, Amazon, Netflix, and Google have returned over 40% per year for the past 5 years while representing almost 25% of the S&P 500 Index and 40% of the NASDAQ. Those stocks are down between 14% (Apple) and 72% (Netflix) so far this year, leading the way for the Tech Wreck we are experiencing at the moment.
It’s hard to know what’s next at this point. Historical evidence shows that we could be close to the bottom of the market dip or at the halfway point of a larger decline. One thing I can be sure of is that companies like Netflix and Peloton still have millions of subscribers and continue to grow, just not at the astronomic rates experienced in 2020. Zoom is here to stay as an important office resource and most of the restaurants I’ve visited over the past year use point of sale technology from Square. I can’t fully explain why each of those stocks have dropped over 60% this year, but they are good businesses with real revenues and attractive growth opportunities, so my expectation is that investors will start to buy those stocks again at some point. The same can be said for most of the stocks that have been beaten up during the Tech Wreck. This is definitely NOT a repeat of the year 2000 when companies like Pets.com, Global Crossing, and Palm went out of business in the blink of an eye. Although I doubt we have seen the bottom of the Tech Wreck, history shows that these companies will experience a recovery at some point on their way to setting new record highs. Hopefully that turning point will happen sooner rather than later.
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