Tech stocks needed a correction, but how big will it be?

Opinion: Valuations moved ahead of earnings growth, but not far enough for a big crash, leaving path unclear

By Therese Poletti, MarketWatch

The recent tech downturn in the stock market have been frightening for some investors, especially those who own the biggest tech giants, but it is needed to readjust expectations that had advanced too far, too fast.

The question investors must now face is, is this is a correction, a bear market or the beginning of something far worse? With the number of still-willing buyers, including the companies themselves, the far-worse scenario seems unlikely, but there is plenty still on the table.

On Monday, the tech-laden Nasdaq Composite Index (COMP)  ended its worst two trading days on a point basis since last September, with a 2.3% total decline, and slight rebounds hit another sharp decline Thursday morning. The huge run-up in the past year of big tech stocks, often referred to as FAANG stocks (for Facebook Inc. (FB), Apple Inc. (AAPL), Amazon Inc. (AMZN), Netflix Inc. (NFLX)and Alphabet Inc.’s Google (GOOG, GOOGL) hit a major roadblock when the two-day tech rout erased nearly $126 billion in market cap from this high-growth group of stocks that have been favored by many investors.

The lofty valuations of those and other tech stocks may have grown too large relative to earnings forecasts, and some entered correction territory early Monday. Investors who understand fundamentals were not surprised that stocks had finally found the need to pull back.

“We just feel like tech was starting to get, and some of the stocks were starting to act, a little hyperbolic,” said Walter Price, lead manager of the AllianzGI Technology Fund. “You might say this is a healthy correction to get expectations back under control.”

A simple correction is not always so easy, however, and can lead to something much darker. The market drop set off reminders of larger meltdowns, especially the 1987 stock market crash and the bursting of the tech-centric bubble in 2000.

“The recent run in large-cap tech stocks has evoked memories (nightmares?) for some investors of the last euphoric Nasdaq run, including yours truly, who was stationed out at the Goldman Sachs offices on Sand Hill Road,” Goldman analysts, led by Robert Boroujerdi, wrote in a report last Friday.

That report, called “Is FANG Mispriced?”, has been cited as one of the potential causes for the current tech meltdown, as it arrived just hours before tech stocks hit a sudden, sharp slide. Goldman’s report, though, is not incredibly negative and speaks rather well of Facebook, Amazon, Apple, Microsoft Corp. (MSFT)  and Alphabet, five companies it describes as “poised to dominate disruption” that have added $600 billion in market cap this year. Netflix (and the graphics chip highflier Nvidia Corp. (NVDA) were excluded from that group because of their much higher volatility.

“Momentum, as a factor, has built a valuation air pocket underneath it, creating cause for pause,” Goldman said.

That air pocket appears to be collapsing, though.

“I think if growth is above the trend line, you have to dial back what you are willing to pay for that growth,” Price said.

For example, Facebook’s stock was up about 33% this year as of Thursday, but earnings are growing at a slower pace. According to FactSet, the consensus on Wall Street for Facebook’s 2017 non-GAAP earnings of $4.90 reflect an increase of about 15.8% year over year.

That type of valuation relative to financial performance is nowhere near what we saw in the dot-com boom, but still needs some kind of adjustment.

“You have to be careful with valuations.” Price said. “You have to be careful with expectations. Episodes like the last couple of days are healthy, they get people thinking about valuations and what they should pay for stocks.”

He also noted that the big drops in the last two days were exacerbated by the index funds that track specific stocks, ETFs and volatility-focused funds — so-called passive investing.

“That is the risk when these strategies are put into place,” he said. “When money flows in and out of those strategies it could have a big impact on the market. I think that is a little bit of a warning sign.”

Price, who recently has been rebalancing Allianz’s tech portfolio to have less Tesla Inc. TSLA, -1.96%  and holding Amazon, after recently trimming it back, sees a continued consolidation trend over the next few weeks, until corporate earnings season in mid-July provides a report card for most of the players in tech.

“As we get into earnings in July, it (the tech sector) will start to do better. I think business is going pretty well,” he said.

By earnings season, some high-flying tech stocks could, and likely should, have experienced a correction, but they are unlikely to hit an extreme skid like the dot-com crash. The stocks could be supported, however, by true believers rushing to buy the dip and companies rolling out cash from some of their multibillion-dollar stock-repurchase authorizations.

Those actions could halt or at least smooth out the decline into earnings season, setting up quarterly reports that could cause even larger swings and more intense scrutiny than usual. Perhaps it is time for financial fundamentals to truly matter more to the tech stocks that have driven the gains on Wall Street for the past few years.

From MarketWatch