Stocks this week flirted with a bear market for the second time in just over two years. Investors looking for the culprit can quite reasonably point to technology stocks as the source of their pain.

It’s been a remarkable turn of events, with shareholders of the most dominant, innovative companies on the planet suffering losses of 30% or 40% in the span of just a few months. The Morningstar US Technology Sector Index is down 27% so this year, led by declines in Microsoft (MSFT) of 22%, Apple (AAPL) down 17%, semiconductor heavyweight Nvidia (NVDA) off 44%, and Salesforce.com (CRM) with a decline of 37%.

Then there’s the communications sector, with household names such as Facebook parent Meta Platforms (FB) down 44%, Netflix (NFLX) a stunning 73%, and Google parent Alphabet (GOOGL) off 22%. Losses such as these have the Morningstar Communications Services Index down 29% so far in 2022.

As investors, the market we’re in makes us face up to some key lessons about stock investing, especially when it comes to valuations, how they matter and why. While the numbers around the tech stock losses are eye-popping, there’s an argument to be made that there are good reasons for their fall.

And as dramatic as the declines have been, and as scary as the headlines are, it’s important for investors to look longer term at the market’s returns. This may end up being a very, very bad year. But 2019, 2020, and 2021 were very, very good years.

Plus, investors playing the long game can use pullbacks as opportunities to take advantage of dislocations in the market and bolster their financial plan. Right now, based on Morningstar’s metrics, technology stocks are the cheapest they have been since March 2009, when markets were beginning to recover from the global financial crisis.

Tyler Dann, head of research for the Americas at Morningstar Investment Management, says investors can glean a number of lessons from the tech stock selloff. "One big lesson is a behavioral one, and it relates to crowding, or a herd mentality—an investment could possess a great deal of merit—a strong business case, impressive growth trajectory, strong balance sheet etc.,'' he says. “But if too many people think the same way it can often drive a disconnect between the price people pay for a stock, and what it's worth. And this can work both ways—to the upside and to the downside.”

Big losses, but after big gains

There’s no doubt that these are big, painful declines given the state of the market and investor sentiment at the close of 2021. At this stage, the downdraft is comparable to other bear markets in history.

For example, technology stocks are down 27.2% from the Morningstar tech indexes’ peak on Dec. 27. The same 138 days after tech stocks hit their peak in March 2000, the sector was down 16.5%. In 2008, tech stocks weren’t hit nearly as hard, but the carnage during that bear market was focused on financials and economically sensitive stocks, rather than tech names.

Tech stocks bear market

Steve Sosnick, chief strategist at Interactive Brokers, says “it’s all a matter of perspective.’’ He points to Nvidia, now down more than 40%.

“If you got caught up in the late 2021 mania surge of growth stocks and tech, you’re down big,”he says. “If you’ve been a long-term investor, it’s been a great performer.” An investor who bought Nvidia three years ago has still nearly quadrupled their money.

Of course, that’s not the case for all stocks that have been down. Netflix is perhaps the poster child for a company stock that has been bludgeoned in 2022, losing nearly three fourths of its value. The stock was up 125% for the prior three years at the end of 2021. Now it’s down a 51.7% for that time span.

2022 Leading Dectractors

Yet overall, that pattern holds true for both the broader tech sector and communication services stocks. The tech stock index is still up 72% over the last three years, and communications has gained 21%. During that time the overall market is up 40%.

3 Year Performance

Valuations don’t matter, until they do

So what happened to these stocks?

“A lot of the current performance is really the result of unwinding their excess performance,” Sosnick says.

Understanding the collapse of tech stocks means going back to the pandemic bear market and recession of 2020. When global economies went into lockdown and stocks spiraled into a free fall, the hunt was on among investors for companies that would best weather the storm.

Many of these companies were considered durable, defensive business models, which were viewed as relatively scarce in the marketplace, Morningstar’s Dann says.

“They got to be crowded investments,” Dann says. “You can’t divorce this (selloff) from valuations. Valuations encompasses expectations. It encompasses the mentality of the market.”

The herd mentality pushed many mega-cap stocks to record highs and hefty valuations. At the end of 2021, the Morningstar tech stock index was carrying a price/earnings ratio north of 29, well above a 10-year average of 20. The communication services index finished the year at more than 21 times earnings, compared with a 10-year average of 18.

Using Morningstar’s price/fair value estimate readings, tech stocks were also well into overvalued territory for most of 2021.

Technology sector valuations

As the pandemic lockdowns ended, other forces came into play.

“Investors fell in love with the idea of disruption,” he says. “It can be a great means to an end, huge fortunes have been built on disruption. But ultimately disruption has to turn into profitability.”

He points to online car retailer Carvana (CVNA). The stock rallied to $360 in August 2021 from a low of around $22 in 2020. It’s now trading below $40. “They are incredibly disruptive, but ultimately they couldn’t turn it into money that would satisfy valuation.''

Don't fight the fed

“Returns were amazing in 2021 and markets can continue to be crazy longer than you and I might think,” says Dann.

Changes in trends generally require a catalyst. In this case, it was the abrupt realization that high inflation wasn’t transitory and that the Federal Reserve was going to have to move aggressively to raise interest rates was a game changer.

“The backdrop has been one of an abrupt regime change,” says Dann. “The predominant theme in the last 40 years has been one of tailwinds for equity and fixed-income investors, where you have lower rates of inflation and relatively steady or declining interest rates.”

“This is making for more of a backdrop of headwinds than tailwinds,” he says.

As has been widely noted in recent months, technology stocks and growth-stock companies in general have been seen as the group most vulnerable to the rise in rates. That’s because a key aspect of stock valuations is estimating the present value of a company’s future earnings. Investors use interest rates to discount the value of those future earnings back to today, and higher rates today diminish the value of future earnings.

Meanwhile, fast-growing companies like tech stocks are usually valued on earnings many years, or even decades into the future. They’re known as long-duration stocks. “When the discount rate rises on long duration investments, what happens is you’re going to get whacked,” Dann says.

What’s next?

Dann says that at Morningstar Investment Management, they’ve been “sharpening their pencils” when it comes to beaten-down tech names, especially big-company stocks that have been ground zero for the selloff.

“While exposure to these names can be achieved in a more broad fashion through buying large-cap, growth-oriented indexes, we think these companies, notably Meta and Google have experienced improved valuation of late,” he says.

These companies are characterized by strong balance sheets, ample free cash flow generation, high profit margins, and returns on invested capital. All of those are a sign of a high-quality businesses.

“While growth concerns, particularly in the case of FB, have begun to assert themselves of late, with the trajectory of future sales and profit growth coming under increased scrutiny, share prices have lagged broader markets, potentially generating an opportunity for longer-term investors that might have underweighted these shares to consider narrowing that underweight,” Dann says.

Sosnick also sees opportunities for investors building among strong companies. “The bad companies are getting thrown by the wayside. Good companies are getting punished, too, but they’re getting punished because they had huge valuations attached to them that were not maintainable,” he says. “You have to take the longer-term view. The good companies are still good companies.”