Explaining the Growth Stock Sell-Off

Is the NASDAQ Rout Rational?

This week’s reader question is about the tech stock sell-off:

Is the recent growth stock sell-off rational, and how long might it last?

Change can be difficult to stomach. After pumping trillions in liquidity into the banking system during the pandemic, the Federal Reserve is poised to pull the punch bowl from the party.

One knee-jerk response? Traders are dumping growth stocks—particularly technology stocks—with abandon. In recent weeks, nearly 40% of the 3,000 stocks in the NASDAQ composite index have fallen at least 50% from their all-time highs. More than 220 well-known companies with market capitalizations of at least $10 billion have fallen 20%. Not even stalwarts like eBay, Netflix, PayPal, Salesforce and Walt Disney have escaped the carnage.

Traders are selling on the assumption that higher interest rates will raise borrowing costs and make future earnings worth less. Fair point—but are they overreacting?

I think so. The fear pendulum has swung too far. Even if the Fed raises rates by 0.25% four times this year, the fed funds rate will be just 1% to 1.25%, and interest rates, when adjusted for inflation, could remain below zero for years. That doesn’t put up much competition for a company that is growing its earnings quarter after quarter—earnings that, after inflation, are still strongly positive.

We’ve seen so-called “taper tantrums” before—extreme selling of stocks ahead of hawkish policy changes at the Fed. Here’s the thing: Higher interest rates aren’t always bad for stocks. On the contrary, the Fed has initiated four hike cycles since 1990, and in each case, stocks gained value. Specifically, the S&P 500 index rose an average of 10.6% as the Fed lifted borrowing rates, and in three instances, stocks went on to rally significantly after hikes were complete.

Rate Hikes and Rallies
Note: Chart shows index level for the S&P 500 as well as the fed funds rate on a weekly basis from 12/28/90 through 1/14/22. Gains displayed during rate-hike cycles do not include reinvested dividends.
Sources: Barron’s, the Federal Reserve.

Curiously, falling interest rates generally signal the more precarious environment for stocks, perhaps because the economy is already in trouble and the Fed is playing catch-up.

Change always introduces uncertainty, but history indicates that these moves by the Fed aren’t as bad as the present market drops suggest. There is a bottom in here somewhere and many potential buying opportunities.

Adam Johnson is Portfolio Manager of Adviser Capital American Ingenuity.

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