Rising bond yields and tightening financial conditions are driving the downturn in a stock market used to cheap money and ample liquidity.

At its recent low close on May 12, the S&P 500 had shed more than 17% since the start of the year as investors fled from risk assets. While the sell-off has been broad-based, growth stocks have borne the brunt.

A decade of historically low bond yields drove investors into established high tech giants such as Apple Inc. and tech disruptors promising future sales, such as Tesla Inc. Historically high valuations are now in freefall as the yield on the 10-year U.S. Treasury has risen from 1.52% at the start of the year to over 3%, meaning future equity returns will be less spectacular relative to assets with less risk.

Tesla's share price is down 28% in 2022, while Apple has fallen about 16%, losing its place as the world's most valuable company to oil giant Saudi Aramco.

Stocks that benefited in the pandemic are in a tailspin. Netflix Inc. — once a member of the lucrative "FAANG" stocks alongside Apple, Alphabet Inc., Meta Platforms Inc. and Amazon.com Inc. — is down 68% in 2022, while indoor fitness group Peloton Interactive Inc. is down 56%.

"Market valuations benefited from the plunge in real rates in 2020 and 2021," said David Lefkowitz, head of U.S. equities at UBS Financial Services. "But as the Federal Reserve begins to normalize monetary policy, and real interest rates move up, valuations are compressing."

With the Federal Reserve hiking interest rates to tackle inflation and expected to begin offloading Treasurys to work down the $9 trillion balance sheet it accumulated during the COVID-19 financial crisis, bond yields could rise further.

Danske Bank expects 10-year Treasury yields to increase to 3.5% in the next six months, while Capital Economics upped its forecast of the peak to 3.75% from 3.1%.

"The equity market weakness is worse now because rates are rising and at the same time there is a pervading fear that higher rates and geopolitical issues could tip economies into recession," said Benjamin Jones, director of macro research at Invesco.

Less liquidity

The prospect of quantitative tightening spells the end of the era of ample liquidity. With the Fed no longer supporting the market with liquidity, assets look overpriced, particularly with a recession a possibility.

"Poor liquidity is one of the driving factors in the magnitude of the sell-off, especially the choppiness of the daily moves," said Jordan Sinclair, director and derivatives research specialist at Capstone Investment Advisors. "In such an environment the price reactions to data, headlines or large trading flows can be higher, both on the upside and downside, leading to more potential volatility and a wider range of outcomes for risk assets."

Total returns in the IT, communication services and consumer discretionary sectors have all been hammered due to their exposure to highly valued growth stocks.

Valuations of growth stocks remain considerably higher than for value stocks. The forward price-to-earnings ratio of the S&P 500 Growth sector is 21.6x as opposed to 15.2x for the S&P 500 Value sector.

"As interest rates fell in the last decade the valuation anchor weakened, and emphasis shifted to the story a company could project. Long duration or meme stocks headed to the moon," Jones said.

With the Fed indicating that the rate hiking cycle is nearer the beginning than the end, there may be further for stocks to fall. A higher-than-expected consumer price inflation print on May 11 may reinforce the Fed's view that it must tighten further.

But as rate cuts have been so clearly telegraphed, it may be that they are now fully priced in. Yields have been dropping back, down from a peak of 3.12% to 2.91% as of May 12.

"If yields fall, because growth is slowing faster than expected and recession probabilities rise meaningfully, then stocks will fall further," Jones said. "However, if inflation slows meaningfully but growth remains resilient, admittedly a very fine line, then central banks will be handed an excuse to slow their rate hikes."