Here's how a downturn is likely to play out for the growth sector.
Recessions tend to be bad news for stocks. After all, stocks get their value from their future cash flows, and in a recession, estimates for future cash flows get dialed down significantly for most companies.
A recession is generally defined as two straight quarters of negative growth, but the real determination is made by the National Bureau of Economic Research (NBER), which defines a recession as "a significant decline in economic activity that is spread across the economy and lasts more than a few months."
While recessions have a negative impact on most industries, they're particularly harmful to cyclical industries where consumers cut back in tough times. One of those industries is the tech sector.
Image source: Getty Images.
The tech sector is broad, including consumer electronics, software, semiconductors, social media, and adtech, among other areas, but all of them are sensitive to the macroeconomic climate. In fact, many of these sectors are already experiencing recessionary headwinds.
Semiconductor companies are experiencing declining revenue. Ad giants like AlphabetandMeta Platforms both reported declining ad revenue in their fourth quarter, and enterprise software companies have complained of falling demand and lengthening sales cycles.
Investors got a sense of that risk last year when tech stocks crashed as the Federal Reserve aggressively hiked interest rates and investors prepared for a recession.
What could happen this time?
A potential recession, paired with elevated interest rates, could be especially problematic for tech stocks. Since most tech stocks are growth stocks priced above the market's average valuation, they tend to be more sensitive to rising interest rates.
That's because higher interest rates make long-dated earnings worth less, so stock valuations tend to come down as interest rates go up.
It has been nearly 14 years since the last sustained recession in the U.S., and the tech sector has changed enormously since then. Multiple companies have reached trillion-dollar valuations, dozens of cloud software companies have gone public at rich valuations, and legacy tech companies like IBMandIntelhave struggled.
During the bear market of 2007-2009, theNasdaq'sdecline of 56% from peak to trough essentially mirrored the 57% decline in the S&P 500.
Considering that tech stocks have already shown more sensitivity than the broad market in the current cycle, they could take a bigger hit in a recession this time around. Valuations still seem stretched by historical standards as many unprofitable software stocks trade at price-to-sales ratios of 10, 20, or even higher.
What's almost certain to happen to tech stocks in a recession is that sales growth will slow, profits will fall or turn into losses, and prices and valuations will come down.
The silver lining
The good news is that tech stocks are generally among the first to surge out of the gate in a new bull market. That's because a recession often prompts the Fed to lower interest rates, and lower rates help tech stocks outperform for the same reason that they tend to underperform in a rising interest rate environment.
We've already seen hints of that recently. Tech stocks have bounced off their lows from the end of 2022 on some signs that inflation is cooling off and that the Fed is slowing down rate hikes, as it only raised the federal funds rate by 25 basis points at its last meeting.
Year to date through Feb. 24, the Nasdaq is up 9.5%, compared to a gain of just 3.7% for the S&P 500.
A number of tech stocks also plunged last year, and those stocks could soar in a recovery. In fact, many of them have already rallied off their lows.
Shopify, for example, had doubled from its bottom in October before selling off after its recent earnings report, andRokuhad also doubled before a recent pullback.
While it's still unclear if there will be a recession, most economists expect one to happen. If it does, expect tech stocks to have an exaggerated pullback, but that will offer a good buying opportunity, as tech stocks should surge in a recovery.
Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool’s board of directors. Randi Zuckerberg, a former director of market development and spokeswoman for Facebook and sister to Meta Platforms CEO Mark Zuckerberg, is a member of The Motley Fool's board of directors. Jeremy Bowman has positions in Meta Platforms, Roku, and Shopify. The Motley Fool has positions in and recommends Alphabet, Intel, Meta Platforms, Roku, and Shopify. The Motley Fool recommends the following options: long January 2023 $57.50 calls on Intel, long January 2025 $45 calls on Intel, and short January 2025 $45 puts on Intel. The Motley Fool has a disclosure policy.
