The steep correction that technology valuations saw in the first weeks of 2022 may ultimately prove to be more boon than gloom for the long-term health of the market.

Following a boom in tech values during the pandemic, the new year brought a period of review. As individual and corporate wealth accumulated and supply chains tightened, inflation began soaring at historic rates. The U.S. Federal Reserve has signaled it will raise its benchmark interest rates in an attempt to realign markets. Investors are now rethinking the massive valuations they have put on growth companies, technology tickers in particular, as they assess the potential risks of an economy in flux.

The Nasdaq dropped almost 15% from Jan. 1 to Jan. 27. While it has since recovered some of that lost ground, the tech-heavy index is still off by 7.4% as of market close Feb. 9.

Market observers see several factors driving the realignment, including inflation, interest rates and a re-focus on fundamental financial metrics. However, analysts argue that this shift in investor sentiment and strategy is a natural thing, and it could represent a healthy, long-term cycle.

Inflation and interest rates

"The big risk is inflation, and at some point inflation has to hinder spending. When spending is hindered and consumers pull back, we will get lower profits. The question is: When will that happen," said Howard Silverblatt, senior index analyst at S&P Dow Jones Indices. "We've all been waiting for some kind of adjustment or correction."

If inflation is part of the problem for tech stocks right now, the bad news is that the macroeconomic cure for inflation — namely, the Federal Reserve's rate increases — also stands to hurt technology players.

Technology valuations have been able to get so high largely because investors have been counting on interest rates at or near zero percent, allowing companies to fund growth without profits. The recent drop in valuations is largely driven by investors pricing interest rates into corporate balance sheets, said Matthew Weller, global head of research at financial services firm StoneX Group.

"If interest rates are zero, people are ambivalent about profits now or profits in the next 10 years," Weller said. "If they go up, even incrementally, investors focus on the direction of change."

Balance feats

The higher valuations over the past few years put a lot of pressure on companies to execute, and there is more downside for investors. It is natural that technology companies, particularly those that are publicly traded but not yet profitable, are being sold out of those high stock prices, said Jay Ritter, IPO expert and University of Florida finance professor.

Markets would likely be stable if there had been a straight-line increase in valuations over the last two years, but the spike in markets seems to have caused a "hangover" effect for investors, Ritter said.

"We've seen many years where growth stocks outperformed value stocks," Ritter said, adding that even the IPO trade, which saw the most activity in 2021 since 1996, was dominated by growth companies with little or no profits.

Investors have been increasingly concerned about the run-up in growth stocks, and there has been an inflow of money into "old economy," or value, stocks, companies that have stable price-to-earnings ratios and often have strong dividend returns.

The S&P 500 Growth Index, which includes companies that have seen strong momentum on sales growth and high price to earnings ratios, underperformed the S&P 500 Value Index after the market boom in late 2020 and early 2021, but then began outperforming again in the summer. That trend has recently flipped, with the value index up 18.1% since Jan. 1, 2021, compared to 16.2% for the growth index.

Riding the cycle

While technology stocks are being hit hard, the shift in investor priority is not a bad thing, as long as faith in the markets is still healthy, Silverblatt at S&P Dow Jones Indices said.

"The funds are reallocating, they are not pulling their money out," Silverblatt said.

The fact that money is remaining in the market is a good sign, he added. While the 0% rate environment priced risk out of investors' calculus for several years, the correction in technology and other growth stocks as a response to inflation demonstrates that risk is still being considered.

Furthermore, corporate profits for most publicly traded companies are strong, consumers are sitting on a cushion of wealth, and while interest rates may go up, there is little sign they will increase tremendously, Silverblatt said.

The secular digital transformation trends that led to the boom in technology valuations through the pandemic are still at play, and those could support technology revenue growth for the next decade, Weller at StoneX said.

These positive secular trends could lead to reinvestment in the technology cycle by midyear, Weller said. Currently, investors are pricing in interest rate hikes up to 5% or 6%, and the Federal Reserve is unlikely to go that high. The last interest rate peaks were around 3% and 4%, and if rates stabilize lower than expected, it could lead to a "buy the dip" trend.

In the meantime

For now, however, volatility remains the rule, with the Nasdaq 100 Volatility Index hitting a one-year peak in January, and those stormy seas will likely persist for at least a couple months, Weller and Silverblatt agreed.

"If you're thin-skinned, it could get volatile here," Sliverblatt advised. "Know your risk tolerance."