Is the latest tech rally a bull trap or a new bull market?

Bear market, new rally, or bull trap?

Optimism that inflation may be reaching its peak has helped US technology shares bounce back in recent weeks. That is stoking investor confidence that the stocks could soon be able to claw back their sharp losses from the first half of 2022.

Since its mid-June low, the technology-heavy Nasdaq Composite Index has risen 23.1% as of 16 Aug 2022, although it is still down about 18.3% year to date.

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Apple, Tesla, Alphabet, Microsoft, Amazon, and Nvidia are some of the tech giants leading the recovery.

But it remains to be seen whether this marks the start of a new tech bull market, or could simply be a short-lived price reversal with the worst yet to come.

On one hand, pessimists think it is a bull trap — a short-term pattern in which stock prices suddenly rise during a downtrend, attracting bullish investors to buy more shares before the price direction reverses. Temporary monthly rebounds have in fact been quite common in previous bear markets.

On the other hand, optimists believe the market has already seen its deepest sell-offs, and that the tech sector remains attractive due to strong secular growth. Some tech shares may also be underpriced now as they were oversold when investors were fleeing the market correction.

So is this an enduring uptrend or just temporary relief? Here are three factors to consider.

Are inflation and interest rate hikes slowing down?

Much of what has been driving US stocks higher stems from investors’ expectations that the country’s monetary policy could ease soon. That comes after several big interest rate hikes by the US Federal Reserve to fight soaring inflation.

Technology stocks are especially vulnerable to rising interest rates. This is because their valuations are often based on the potential for future earnings, and the present value of their future earnings is worth much less when interest rates go up. 

In particular, loss-making, high-growth tech stocks tend to be hit harder as their cash flows are further into the future, as compared with value-oriented companies.

When the Fed was raising rates in the first half of 2022, tech plays recorded bigger price drops than the rest of the stock market.

Conversely, technology shares face less pressure when there’s an interest rate cut or a slowdown in rate increases, as lower rates can support higher valuations for these stocks.

Inflation in itself creates a challenging environment for most companies across industries. The higher component and labour costs will threaten profit margins if the companies do not have enough pricing power to pass the costs on to customers. 

If inflation stays higher for longer, the Fed is likely to continue tightening monetary policy aggressively. However, the latest tech rally shows that many investors believe these rate hikes will soon slow down as inflation appears to be cooling off a tad.

The US central bank’s latest decision was to raise rates by another 75 basis points, or 0.75%, on 27 July. To be sure, Fed chair Jerome Powell has said a similar move was possible again, although he also noted that at some point the central bank will reduce the pace of increases.

Recent data suggested that inflation may in fact have peaked, although it remains near the highest levels since the early 1980s. Prices of commodities have come down, and gasoline or petrol prices have also dropped.

The slump in energy prices helped the US consumer price index rise at a slower-than-expected pace of 8.5% in July 2022, according to figures released on 10 Aug.

For stock prices to sustain their upward momentum, there needs to be clear and greater signs that inflation will not continue rising.

If inflation figures in the coming months are worse than predicted, expectations of slower rate hikes by the Fed could subside and thus cause stock prices to fall again.

Keeping an eye on the data that informs the Fed’s actions — be it a rate hike or cut — will give investors a better idea of where stocks are headed next.‍

Is a global recession looming?

The economic backdrop also affects the stock market’s performance; not all sectors will be able to weather a global recession. With more volatility and headwinds likely to be on the cards, recession fears are growing and companies are bracing for tougher times ahead.

Morgan Stanley noted in a recent report that "a host of unknowns" such as the Russia-Ukraine conflict, China’s economic recovery, and the Covid-19 pandemic’s lingering impact remain outside the Fed’s control.

In addition, equities are trading at valuations that don’t look cheap enough to appropriately value the true uncertainty in today’s environment, Morgan Stanley said.

Besides inflation and higher interest rates, companies are also dealing with widespread supply-chain disruptions around the world. The ongoing shortage of semiconductors, or chips, has held up the production of automobiles and consumer electronics such as smartphones, computers, and cameras.

Moreover, these economic worries are causing advertisers to cut spending, which hurts tech companies that depend on ad revenue, including Google and social media platforms like Facebook and Twitter.

When the economy shrinks and people tighten their purse strings, consumer discretionary companies — which sell non-essential goods and services such as cars and entertainment — tend to be more sensitive, as consumers will reduce or postpone such purchases. 

Many major tech businesses, such as electric vehicle makers and e-commerce sites, are part of the consumer discretionary sector. 

The US economy contracted for two straight quarters, with a 0.9% drop in gross domestic product (GDP) in Q2 2022, which matched the common definition of a technical recession. However, both the White House and the Fed have said that the world’s largest economy is not yet in recession. 

Economists have also pointed out that the job market remains healthy and consumer sentiment is picking up from record lows, although the outlook is still far from rosy. 

The economy is not yet out of the woods — it needs time to absorb the full impact of the Fed’s huge rate hikes and tighter financial conditions, recession remains a real risk, and the cost of living is still going up.

Only when there is consistently strong economic data and far less uncertainty swirling around, can investors be more confident that the stock market has bottomed out.

What’s next for Big Tech earnings?

It’s also worth paying attention to the earnings and fundamentals of technology companies. Tech analysts have flagged possibly significant downgrades to earnings in 2022 and 2023. 

For instance, profit forecasts for the Nasdaq 100 index — made up of large-cap stocks on the Nasdaq exchange such as Alphabet, eBay, Nvidia, and PayPal — were lowered after companies reported their financial results for the second quarter this year. These included a 5.5% reduction in the 2022 forecast and a 6.5% cut to the 2023 estimate, which could erase billions of dollars from US tech firms’ earnings, The Financial Times reported.

Sound fundamentals, robust business models, and dominance in the market are some factors that will help companies stay resilient and ride out economic downturns.

Apple, Microsoft, Amazon, and other Big Tech are said to be acting responsibly to navigate the challenges of supply constraints, rising costs, and changes in consumer spending. For instance, some large tech companies that are fundamentally strong have been taking precautions and making prudent cost-cutting decisions, such as slowing the pace of hiring.

Structural factors — such as the renewed attention on environmental, social, and governance (ESG) factors amid the climate crisis — can also support the long-term growth, profitability, and margin potential of certain tech sub-sectors.

Use dollar-cost averaging to invest in a disciplined way

Bear markets and steep sell-offs are often followed by quick rallies — which do not always last. Price reversals can perplex even the most experienced and professional investors. 

Increased volatility tends to lure those seeking near-term gains into making multiple trades as they try to time the market. But this carries the risk of deep losses and may cause investors to lose confidence in the underlying asset.

The truth is, nobody knows with absolute certainty if the market has reached its absolute lowest point, or whether more losses are on the cards. It is incredibly difficult to accurately time the market. Even so-called experts have been proven to be bad at it.

Instead, time in the market is key. Being disciplined by using a dollar-cost averaging (DCA) strategy enables you to ride out these bouts of volatility. During choppy periods, it is a good idea to exercise caution and avoid making big changes to asset allocations that differ from your long-term risk-based targets.

DCA refers to periodic, recurring investments of a fixed amount into your portfolios — a strategy that helps to minimise the impact of volatility. The discipline and routine of investing money over the long term removes the emotional element so that you are not tempted to jump in and out of the market.

At Endowus, we take a long term approach when it comes to investing. A broadly diversified, strategic and passive asset allocation at low cost, with enough time in the market, is how your wealth will grow steadily over time through the power of compounding returns. Click here to get started with Endowus.

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Investment involves risk. Past performance is not an indicator nor a guarantee of future performance. The value of investments and the income from them can go down as well as up, and you may not get the full amount you invested. 

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