Investors pivot to value stocks amid tech rout

With the 3rd Quarter earnings season underway, the recent rout in big technology stocks bolsters the bearish thesis of 2022. The tech sector faces fierce headwinds from a strong dollar, compressing margins, and weaker advertising growth, which is often considered a leading indicator of recessionary headwinds.

Over the past several years, many of the largest tech stocks – think Alphabet/Google, Apple, Amazon, Meta Platforms/Facebook, and Microsoft – have rewarded investors with lofty valuations, benefited from zero-bound interest rates, embarked on massive hiring binges, and traded profitability for large capital expenditure budgets. Now their historic levels of overvaluation and the multiples applied to them (sometimes justifiable) are under pressure as the combined headwinds of inflation and macroeconomic forces challenge the revenue environment. The rotation out of growth stocks and into more value-oriented stocks is likely reasonable.

Notably, the weighting of big tech in the S&P 500® Index might temper any future rally as a rotation out of big tech toward value appears to be underway. For an illustration, consider the S&P 500 Index of these specific tech behemoths: Apple – 7.0%; Microsoft – 5.7%; Alphabet/Google – 3.6%; Amazon – 3.3%; Meta – 0.9%. Without help from large-cap tech, the case for a substantial rally for the S&P 500 is likely diminished.

Another warning sign for investors to monitor is the price-to-free cash flow of big tech, which has seen double-digit growth over the past few years but is now declining. Massive capital expenditures and dwindling advertising revenue are finally catching up as recessionary headwinds approach. To illustrate, Meta Platforms now has a free cash flow of less than $1 billion, down from $9.5 billion last year. Shockingly, Meta’s recent guidance on future capital expenditures was in the $34-39 billion range, well ahead of consensus estimates. Microsoft and Alphabet also announced lackluster performance, driven by weaker cloud computing and personal computer growth, foreign exchange headwinds, and a slowdown in advertising revenue. This might indicate that these firms are no longer immune to cyclical headwinds, and given the current macro backdrop, investors might be better served focusing on a value-oriented allocation.

Together, these observations signal that a rotation from mega-cap tech might be underway as earnings projections for 2023 favor value and small-cap stocks. For years, investors have favored high-flying stocks of companies that promise high above-average growth while ignoring their value-oriented counterparts. As interest rates and macroeconomic headwinds continue to pressure the future earnings and dividend streams of mega-cap stocks, value-oriented and small-cap stocks may offer opportunities in a climate of rising rates.