The Reason Once-Invulnerable Tech Stocks Are Cratering

Since the Federal Reserve has indicated it is going to raise interest rates to fight inflation, the markets have begun to crater, especially the tech stocks which have led it progressively higher for over a generation. 

The reason is that future earnings make the prospect of continued growth less likely, especially for speculative companies so dependent on future prospects, rendering such investments riskier. The stock market collapse of 2022 is largely about that party being over, particularly since 31% of small cap stocks are unprofitable and, due to these new developments, may never be.  JL

Karen Langley reports in the Wall Street Journal:

During the market selloff of recent weeks, investors have been shedding speculative investments from tech stocks to cryptocurrencies. Speculative investments with their promise of higher returns thrived in the ultra-low-rate environment of 2021. Now that the Federal Reserve may raise interest rates as soon as March to combat inflation, investors are less comfortable with risk. The prospect of rising interest rates has been especially hard on the small-cap index, in large part because of the high proportion of small-caps that aren’t making money. 31% of the Russell 2000 were unprofitable as of the end of 2021.

The prospect of rising interest rates has been especially hard on the Russell 2000 small-cap index, in large part because of the high proportion of small-caps that aren’t making money.

During the market selloff of recent weeks, investors have been shedding speculative investments from tech stocks to cryptocurrencies. Speculative investments with their promise of higher returns thrived in the ultra-low-rate environment of 2021. Now that the Federal Reserve may raise interest rates as soon as March to combat inflation, investors are less comfortable with risk.

The companies in small-cap index funds tend to have less-diversified business lines and more of a chance of not turning a profit.

 

Companies making up 31% of the Russell 2000 were unprofitable as of the end of 2021, according to an analysis from Jefferies of earnings over the previous 12 months. By contrast, 5.7% of the Russell 1000 index of larger firms was made up of companies without earnings.

Russell 2000 stocks, share-price performance this year and net income in the past 12 months

60%

30

PRICE PERFORMANCE, YTD

0

Trend line

–30

Unprofitable

decliners

LOSSES

PROFITS

–60

–$1.5

–0.75

0

0.75

1.5

NET INCOME, LAST 12 MONTHS (BILLIONS)

Note: Limited to Russell 2000 stocks with market value of at least $1 billion. Excludes companies for which 12-month net income is unavailable. For display purposes, four outliers were excluded: Southwestern Energy ($2.5 billion loss, 10.7% price decline), AMC Entertainment ($2.1 billion loss, 38.8% price decline), California Resources ($3.7 billion profit, 5.4% price decline) and Chesapeake Energy ($4.5 billion profit, 1.2% price decline).

Source: FactSet
Graphic by Peter Santilli/The Wall Street Journal

That disparity has been apparent in the performances of the indexes in recent weeks. Even with its 2.3% gain Monday, the largest among the major U.S. stock indexes, the Russell 2000 has dropped 17% since its record close in November. The Russell 1000, by contrast, is down just 8.4% from its record, according to FactSet.

“The nonearners are the riskiest of risky stocks,” said Steven DeSanctis, small- and midcap strategist at Jefferies. “These stocks generally do awful, very poorly, in front of a Fed hike.”

Within the Russell 2000, shares of companies without earnings have fallen further this year than has the index as a whole, according to Mr. DeSanctis. News early this month that the Federal Reserve might raise interest rates as soon as March has shifted investors’ calculations within the stock market, making far-off earnings less attractive.

Small-cap companies with net losses over the past 12 months, according to FactSet, include online fashion company Stitch Fix Inc., cosmetics company Revlon Inc., drugstore chain Rite Aid Corp. and biopharmaceutical company Cytokinetics Inc.Shares of Stitch Fix have slid 14% year to date, while Revlon shares have declined 17%, Rite Aid shares have lost 25% and Cytokinetics shares have fallen 31%.

Shares of companies that promise high future growth have also lagged behind the broad stock market year to date. The Russell 1000 growth index, for example, is down 12% in 2022, while the Russell 1000 value index has dropped just 3.6%. Growth stocks are losing out to value stocks among the small-caps as well.