Don't Panic Over Recent Tech Turmoil

U.S. investors have understandably been disturbed by the dramatic selling that has slapped down high-flying momentum stocks in the Internet and biotech sectors.

Tesla (NASDAQ:TSLA), Netflix (NASDAQ:NFLX) and Facebook (NASDAQ:FB), all among the biggest winners in 2013, have plunged more than 20% from recent highs, tumbling into bear market territory. The carnage has prompted some to worry this is just the first shoe to drop before a more prolonged slump that hits the broader markets.

But not all pullbacks are unhealthy. In fact, some veteran observers said the sell off in momentum stocks may actually be a longer term positive for investors because it lowers the chances of a melt-up, or bubble, in prices. Plus, the resulting focus on value stocks may signal renewed confidence in the U.S. economy.

“It still looks like a healthy internal correction that might actually be good for the longevity of the bull market,” Ed Yardeni, president of investment advisory Yardeni Research, told clients in a note on Tuesday.

If that’s the case, bullish investors may even take the recent pullback as a chance to scour the markets for stocks that have been unnecessarily dragged down by the tech carnage.

“I don’t subscribe to the view it’s a symptom of something broader in the economy or in the markets. For that reason, I think it may be a buying opportunity for the broader market,” said David Joy, chief market strategist at Ameriprise Financial (NYSE:AMP).

Some investors are apparently thinking the same, driving the Nasdaq Composite nearly 1% higher on Tuesday amid rebounds for stocks like Google (NASDAQ:GOOG) and Yahoo (NASDAQ:YHOO).

Biotech Stocks Slammed

The tech tumble began last month with a nasty slide in the biotech sector. Concern was exacerbated by a March 21 letter that Rep. Henry Waxman fired off to Gilead Sciences (NASDAQ:GILD) over the pricing of a Hepatitis C drug.

Since March 21, the iShares NASDAQ Biotechnology Index ETF (NASDAQ:IBB) has declined 12.2%, compared with a 1.2% dip for the S&P 500. Some individual names like Biogen (NASDAQ:BIIB) suffered even steeper drops.

“You see this episode in momentum stocks all the time. They get to a point where they are overextended. Eventually gravity takes over."

- David Joy, chief market strategist at Ameriprise Financial

That helps explain why the Nasdaq Composite is in the red on the year and suffered a sell off of 4.6% in the three trading days ended on Monday, its worst three-day percentage drop since November 2011.

Joy advises investors to be “cautious” in the short-term on biotech stocks, though he concedes at some point a buying opportunity may emerge.

“I’m not brave enough to step in at this point,” he said. “Longer-term, I think biotech is probably worth having some exposure to. It’s a dynamic part of the economy, but clearly valuations got ahead of themselves.”

Internet Valuations Questioned

Compounding the Nasdaq’s headaches, some Internet stocks have been in free fall. Twitter (NYSE:TWTR) has plunged 33% so far this year, while Netflix is down 5%.

“The Internet names are even more difficult to value than the biotech. You have to have a lot of faith that the business models of these companies are sustainable and can turn into real earnings growth over time,” said Joy.

Of course, investors had no qualms about gobbling up these high-flyers when the momentum was to the upside, constantly luring in new buyers who didn’t want to miss the move.

Yardeni said it’s hard to say what’s causing the meltdown in momentum stocks, other than that their “valuation multiples flew too close to the sun.”

The ugly initial public offering for “Candy Crush Saga” maker King Digital Entertainment (NYSE:KING) on March 26 couldn’t have helped. Nor did a March 29 article in Barron’s that questioned how online ad spending can grow at a fast enough price to justify the valuations on dotcom stocks.

“You see this episode in momentum stocks all the time. They get to a point where they are overextended. Eventually gravity takes over and they start to come back down,” said Joy.

Some of the selling in tech and biotech stocks may have been exacerbated by margin calls by big banks worried about their exposure to swings in the market as well as interrelated trades that suddenly became overcrowded.

The last thing big banks “need right now is for an outside party, i.e., a big prime brokerage client, to blow them up by owning too many biotech stocks or not enough Turkish lira,” Michael Block, chief strategist at Rhino Trading Partners, wrote in a note on Tuesday.

Focus Shifts to Value Names

High-beta stocks, including volatile momentum plays, tend to under perform Wall Street during periods of subdued market performance.

According to BMO Capital Markets (NYSE:BMO), since 1990 high-beta stocks have averaged a one-year return of -4.2% when the S&P 500 gains between 0% and 5%, compared with a more robust return of 12.5% when the benchmark index advances 5% to 10% and a 24.7% rally when the S&P 500 jumps more than 10%.

Brian Belski, chief investment strategist at BMO, urged clients in a recent note to avoid singular beta strategies and instead focus on “areas with sound fundamentals, which we believe is the necessary ingredient to support higher stock prices.”

While cash has been flowing out of high-flying stocks, investors have been pouring more money into more value-oriented names since February. Value and dividend-paying stocks like AT&T (NYSE:T), Verizon (NYSE:VZ) and McDonald’s (NYSE:MCD) have outperformed of late.

When earnings and economic growth are slow, investors tend to favor stocks that have upward momentum. However, when fundamentals improve, Wall Street turns back to undervalued growth stocks that are more sensitive to economic conditions.

“I think the economy is getting stronger and I don’t think the broader averages reflect that yet,” said Joy. If the economic data backs that up, “the underlying rotation into value stocks has some longevity to it,” he said.

That rotation into value stocks halted momentum stocks before their valuations got even more out of whack with fundamentals.

“Their sell off might lower the risk of a broader market melt-up that would be followed by a much broader meltdown,” said Yardeni.