With a recession around the corner, the Fed isn’t finished devaluing Silicon Valley’s mountains of monopoly money

(Originally published Feb. 6 in “What in the World“) The tech industry is staring into a looming recession that threatens its underlying business of selling hardware, software and ads against largely free, user-produced content. So why are its stocks climbing?

The answer has less to do with smart technology than with the monopoly power of mountains of cash. Here’s a quick rundown of the industry earnings carnage last week and how the market responded:

Amazon: fourth-quarter net profits fell 23% year-on year on a 9% increase in sales that was the slowest growth in decades. Amazon isn’t as dependent on advertising as other tech companies with social media platforms, but its own 19% increase in ad revenue was more than offset by a 2% decline in online store sales that illustrates why the ad business overall is weakening. Growth in its corporate cloud business also slowed. Amazon’s stock finished the week up 1.5%. AMZN -1.39%↓

Microsoft: net income fell 12% in Q4 on a 2% increase in revenue that was the slowest growth in six years. Also less-reliant on advertising than social-media companies, Microsoft blamed slower demand from companies for its cloud-computing business. Its stock finished last week up 4.2%. MSFT 1.49%↑

Alphabet: Q4 net profits fell 34%, the fourth consecutive quarterly decline, on a 1% decline in sales, as the online advertising market slows. Alphabet faces new competition for its mainstay Google search engine from artificial intelligence offerings like ChatGPT, into which Microsoft earlier this month announced what was reportedly a $10 billion investment. It faces an antitrust lawsuit from the U.S. Justice Dept., which alleges that it monopolizes online advertising. Alphabet’s stock rose 5.2%. GOOG 0.26%↑

Meta: Q4 net dropped 55% on a 4% decline in sales, its third straight decline in sales, despite adding users at Facebook and Instagram. Its stock closed the week up 24%. META 1.29%↑

Apple: Q4 net fell 13% on a 5% decline in sales, the first in three years. Apple faces manufacturing disruptions in China (and is trying to shift to India), which helped send iPhone shipments down almost 15%. Its stock closed the week up 6.6%. AAPL 1.05%↑

There are a lot of explanations for why investors rewarded the industry for its terrible, no-good results, none of them accurate. One is the adage that investors tend to “sell on news,” meaning they build a position predicting what will happen, then reverse or close that investment once the news confirms or disproves their thesis.

In this case, investors who were shorting tech stocks ahead of earnings would have covered their positions after the earnings, helping send the stock prices back up. That was certainly a factor last week, particularly as prices rose and short sellers were “squeezed,” but can’t fully account for the paradoxical performance of tech in a week when it made clear its dimming fortunes.

Another explanation is that tech earnings may have been bad, but they were better than investors feared. But not true in this case. While Amazon and Meta’s sales were higher than forecast, their net profits fell short of consensus estimates. Alphabet, Apple and Microsoft all reported sales and net profits below analyst forecasts.

That left reporters grasping for another hopeful message: the industry is getting serious about cutting costs, a cold splash of reality that contrasts sharply with the industry’s strategy so far of buying sales and spending its way into new profits. “We’re on an important journey to re-engineer our cost structure in a durable way and to build financially sustainable, vibrant, growing businesses across Alphabet,” Google CEO Sundar Pichai said. Meta’s CEO Mark Zuckerberg said 2023 would be “the year of efficiency.”

Pull the other one. Belt-tightening into a slowdown is never a sign of growth. Besides, except for older companies such as Apple and Microsoft, investors have never been much bothered by profitability at tech companies, as their sky-high price-earnings multiples have long demonstrated. Indeed, in those terms Alphabet and Meta are finally priced at reasonable prices for the first time in years, something that did little for their stock prices over the past year.

Instead, the popularity of giant tech companies centers on their ability to amass and deploy massive mountains of cash. Meta provides the simplest illustration: Meta’s stock soared 25% after the company’s earnings report because the company authorized a $40 billion increase in its share buyback program, potentially putting a floor under its share price. Many, if not most, reports mischaracterized this as an announcement to actually buy back $40 billion worth of shares, an amount roughly equivalent to every penny of cash on Meta’s balance sheet and more than a tenth of its market capitalization.

In fact, Meta has been buying back its own shares since 2017, and last year authorized a $50 billion increase in buybacks, which didn’t keep its stock from falling 56% over the next year. That’s because Meta doesn’t buy back as much as it authorizes and only began buying back more than $10 billion of shares a quarter in 2021. The idea is to use the threat of a buyback to keep shares from falling as much as they might.

Tech companies also use buybacks as an alternative to paying out dividends. Buybacks are at management’s discretion, after all. Dividends are something to which management must commit. Investors often prefer buybacks, too, as they’re subject to tax on only the profits they earn from what shares they sell, whereas dividends are taxed at a flat rate.

But Meta’s buyback still doesn’t explain the rally in tech shares despite the industry’s lackluster results. And the answer, again, comes back to cash. Investors are generally dazzled with tech companies and have treated them like big piggy banks due to their cash flow, ignoring profitability to look instead only at their revenue growth and cash flow, despite the fact they haven’t don’t pay much of that cash back to them.

That’s because tech companies are supposed to be reinvesting their cash into developing new technology, so investors are willing to accept lower profits provided the company generates sufficient cash to remain solvent.

But the tech giants long ago moved past using cash to ensure their solvency as they took risks on innovation. The tech giants maintain some of the world’s biggest piles of cash. Microsoft is sitting on $158 billion in cash and equivalents. Amazon has $147 billion. Apple has $129 billion. Google has $114 billion. Meta has just $56 billion, so no wonder it’s threatening to hand almost all of it over to investors to prop up its share price. And apart from Apple, these cash piles far exceed current liabilities, giving them huge net cash positions.

These cash piles help make the companies “too big to fail”—and not only from the point of view of their creditors. With enough cash, you simply can’t lose. If an investment into a new product or innovation doesn’t pan out, no problem: just buy one that does. If an upstart competitor outshines you, buy it out. If that sounds like a recipe for monopoly, that’s because it is.

But that means that tech stocks depend more on their ability to keep generating bigger mountains of cash so they can keep buying sales and (hopefully but not necessarily) profits. And that’s where it starts to get tricky for tech. Their cash mountains have been dwindling.

It also means that the value of tech companies’ cash and the relative cost of risking it on development and acquisitions depends on the cost of cash, i.e., interest rates. If inflation is high and rising, as it is now, the real value of those cash piles diminishes. And if interest rates are rising, as they are now, the relative return needed to justify investing that cash (i.e., the risk) also rises.

So, tech stocks depend even more on the direction of inflation and interest rates as they do signals about tech companies’ underlying business. The rally last week in tech shares may have less to do with companies’ results and outlook, therefore, than it did with Wednesday’s 25 basis point rate increase by the U.S. Federal Reserve. Coming after several 50 basis point increases, the market took the move as a signal that inflation is cooling, and that the Fed will probably only raise rates one more time. Indeed, the market is already pricing in rate cuts later this year as the economy cools.

But economists warn that the market is being overly optimistic about the Fed’s desire to tune rates to the economy. Yes, a recession is coming, and that won’t be good for sales of the stuff tech companies sell, whether it’s iPhones, Outlook Office or ads directed at you by spying on your email and Instagram “likes.”

While the Fed talks a lot about the economy, stimulating economic growth and avoiding recessions are not its priority. The Fed’s mandate is instead twofold: stabilize prices (i.e., control inflation) and avoid unemployment. That’s why Friday’s surprisingly strong job data have sapped what confidence the market took from Wednesday’s rate hike. The new data means the Fed may not be close to done raising rates after all, something the Fed itself has signaled.