The tech stock 'fairy tale' is heading for a bad ending

Tech giveth, and tech taketh away.

And the formerly red-hot sector has been doing quite a bit of taking over the past two days.

The Nasdaq 100 Index, which is heavily weighted towards tech, has slipped 3.3% since Friday, erasing roughly $300 million of market value amid mounting concerns that the space got overheated on its way to new record highs.

The jarring selloff has highlighted the fragility of a tech rally driven largely by a small handful of high-flying mega-cap stocks that are more heavily owned by large fund managers than at any other point in the eight-year bull market. That includes the so-called FANG stocks - Facebook, Apple, Netflix and Google - and others, like Nvidia.

The sector's swift fall from grace also shows just how perfect the conditions were that led to its equity market dominance - conditions that, when unwound, can wreak havoc not just on the elite few companies leading the rally, but also those clinging to their coattails.

"Just like in the fairy tale, this perfect scenario is unlikely to last," Goldman Sachs chief US equity strategist David Kostin wrote in a client note on Friday.

He's describing the ideal conditions that drove a 21% year-to-date gain for the Nasdaq 100 through last Thursday. While profit growth has shown signs of strength, economic conditions have stayed subdued enough to keep potentially runaway valuations in check, said Kostin.

That harmony was disrupted last Friday when Robert Boroujerdi, head of global securities research at Goldman, published a report warning of complacency around Facebook, Apple, Amazon, Microsoft and Google. The realized volatility for the group of stocks is lower than the broader market, which may be giving investors the false impression that risks are subdued, he said.

As many traders found out the hard way on Friday, risks are very much alive and well, even for seemingly unassailable stocks like Apple. The tech giant has slipped 6.4% since Friday amid a report from Bloomberg that the upcoming iPhone 8 won't be as fast as its rivals. The company's woes continued on Monday after Mizuho analyst Abhey Lamba downgraded his buy rating on the stock to a hold, citing limited upside.

The rash of weakness across the whole tech sector shows just how precarious sharp shares gains can be, and how quickly they can go south. That dynamic is amplified when a trade is crowded, as mega-cap tech was heading into last Friday's reckoning.

Facebook, Amazon, Google and Apple represent four of the six stocks most frequently found in the top 10 holdings for hedge funds, according to an analysis conducted by Goldman, which looked at 821 hedge funds holding a total of $1.9 trillion in gross equity positions.

Tech bears will also point to elevated valuations as a reason for the sector's selloff. After all, the ratio of enterprise value to sales is the highest since the dotcom bubble when compared to the benchmark.

But not everyone agrees. Bulls will point to the more traditional price-to-earnings ratio (P/E), which remains low relative to history for both the tech sector and the broader S&P 500.

Regardless of which metric gives a superior reading, investors on Friday elected to immediately pull money out of tech stocks and ask questions later.

The SPDR Tech Select Sector ETF, which tracks tech companies in the S&P 500, saw a $560 million outflow on Friday, the biggest single-day removal since January 30, according to Bloomberg data. The trailing five-day outflow amounted to $737 million, which was the biggest weekly figure since the early 2016.

The recent market action has left Morgan Stanley unworried. In fact, the firm wasn't caught off-guard at all by the sudden weakness in tech, and it expects matters to worsen in the short-term.

"We think this was way overdue given the extreme outperformance and positioning in technology shares," a group of analysts led by Michael J. Wilson wrote in a client note on Monday. "We don't think it's over and expect some follow-through this week."

However, Wilson highlights the sector's torrid earnings growth, which is among the best in the S&P 500. Tech companies in the benchmark saw 21% profit expansion in the first quarter, the best out of any group, Bloomberg data show. It's expected to see 14% earnings growth in the second quarter, almost double that of the S&P 500.

Morgan Stanley is also encouraged by the resilience of the S&P 500, which has only slipped slightly while the Nasdaq 100 has experienced much deeper losses. The firm has a 12-month price target of 2,700 for the S&P 500, which would be an 11% increase from Friday's close.

"The fact that the Nasdaq could sell off 2 percent but leave the broader S&P 500 essentially flat is a good sign that money is not leaving equities, but simply repositioning," said Wilson. "In our view, that is supportive of our view that this is a correction not the end of the bull market."