Most investors have a set of tech stocks in their stock-market portfolio, whether it is Tesla, Facebook, Amazon, Apple, Google…etc. This is because tech stocks have become an essential part of the stock market through the Nasdaq Composite, which tracks the 100 best tech-based companies. What makes tech stocks special is that they have a very large market capitalization and they represent a very strong potential for future growth.
However, tech stocks tend to be very volatile compared to value stocks. And one of the reasons why tech stocks are quite volatile is due to their high correlation with interest rates. Why are tech stocks highly correlated with interest rates? There are a few reasons which explain that correlation.
First, tech stocks are typically growth stocks. Indeed, growth stocks are companies that are expected to grow at a faster rate than the overall market. These companies tend to have high valuations, meaning that their stock prices are high relative to their earnings. When interest rates rise, the value of future earnings decreases, which can lead to a decline in the stock prices of growth stocks.
Second, tech stocks often have high debt levels, and even become overleveraged. Many tech companies borrow money to fund their growth. When interest rates rise, the cost of borrowing money increases, which can weigh on the profitability of tech companies.
Third, tech stocks are often more sensitive to economic downturns than value stocks. When the economy slows down, businesses tend to cut back on spending, including spending on technology. This can hurt the revenue and earnings of tech companies.
Inflation can hurt any company without the power to raise prices, but tech stocks can be affected even more since inflation is usually followed by periods of rising interest rates. Additionally, smaller tech companies without meaningful profits may be unable to absorb price increases from their suppliers.
Higher interest rates lead to a higher cost of capital. When interest rates rise, it becomes more expensive for tech companies to borrow money to invest in new growth opportunities. This can slow down the growth of tech companies and make them less attractive to investors.
Interest rates, when they are high, lead to a lower present value of future earnings. Certainly, tech companies are often valued based on the expected value of their future earnings. When interest rates rise, the value of future earnings decreases, which can lead to a decline in the stock prices of tech stocks.
Lastly, higher interest rates create a shift in investors’ sentiment. Investors tend to favor more defensive stocks during periods of rising interest rates. This is because defensive stocks are typically less volatile and more resilient to economic downturns. As a result, tech stocks may underperform the overall market during periods of rising interest rates.
However, it is important to note that not all tech stocks are affected by interest rates in the same way. Some tech companies, such as those that provide essential services or have strong brand loyalty, may be more resilient to rising interest rates. However, in general, tech stocks are more sensitive to interest rates than other sectors of the market.