Tech Stocks Face Acid Test As Fed Hikes Loom

By Ven Ram, Bloomberg markets live commentator and reporter

Technology stocks have been feeling the heat. They may continue to come under pressure as the Fed prepares to raise rates to quell inflation, an analysis of Nasdaq stocks that parses them as lower-rated bonds shows.

The Nasdaq 100 basket of stocks may decline more in the months to come, and end next year with a whimper should earnings growth revert to the long-term trend while Treasury yields push higher simultaneously.

The projection assumes that technology stocks trade like riskier bonds that come with the promise of higher coupons, but exhibit a significantly higher variance of returns. In other words, investors can correctly price these securities by factoring in a spread to the default-free curve, akin to the concept of a Z-spread.

The study assumes that two-year Treasury yields will rise to around 1%-1.20% by the end of next year if the Fed were to raise its benchmark twice by then, and estimates a spread of 300 basis points for the earnings yield. Front-end yields have climbed by an average of 0.71 basis point for every basis-point increase in the Fed funds rate during previous tightening cycles going back to the start of 1999.

Forward estimated earnings per share on the Nasdaq 100 have grown at a compounded annual rate of about 14% since the dotcom bubble burst, which is a key assumption in the base case set out in the table above. The other three scenarios assume that the combined earnings per share will grow at 10%, 20% and 30%.

The conclusions are clear: unless earnings grow well above the long-term average, technology shares will face an uphill battle next year — even more so if the Fed were to raise rates at a more aggressive pace than factored in by the markets.

A key risk to the view is the continued abundance of systemic liquidity, which ensures never-ending demand for even riskier assets. Indeed, buy-the-dip has been a constant refrain in the past few years.

Stocks may yet be supported if long-end yields stay stubbornly low, forcing pension funds and endowments to keep buying technology and other stocks. That is a stronger possibility than it looks, given that it’s hard to find even a 2% sovereign yield in the G-10 universe.

A return to work-from-home — as we’ve seen more and more companies do in recent weeks — may ironically spur demand for technology consumption, as happened immediately after the pandemic. That would again boost earnings by more than the trend average, supporting current valuations.

Even so, valuations have run up astronomically in recent years. Indeed, price gains in the Nasdaq 100 have outpaced earnings growth in the past five years, suggesting some caution may be warranted