What happened
Shares of top technology growth stocks Snowflake (SNOW -0.26%), HubSpot (HUBS 2.55%), and Datadog (DDOG 1.19%) plunged today, with shares down 5.4%, 6.2%, and 7%, respectively, as of 1:15 p.m. ET.
There wasn't any material news out of any of these companies today; therefore, the culprit was most likely macroeconomic. While high-growth software stocks actually may have benefited from recessionary fears over an inverted yield curve last week, it was long-term rates that spiked on Tuesday, which actually reversed the inversion.
Higher long-term interest rates are a headwind to high-growth stocks, leading to the big moves we saw today.
So what
This morning, Federal Reserve Governor Lael Brainard, who had been known to be one of the more dovish Federal Reserve officials, gave some surprisingly hawkish comments, specifically with regards to the Federal Reserve unwinding its balance sheet.
In a prepared statement, Brainard said: "Currently, inflation is much too high and is subject to upside risks. The Committee is prepared to take stronger action if indicators of inflation and inflation expectations indicate that such action is warranted."
There has been lots of handwringing as to whether the Federal Reserve will tighten so quickly as to push the economy into a recession to tame inflation. However, high-growth software stocks, with their recurring revenue and secular growth outlook, tend to outperform when recession fears are high. So why is today different?
Ironically, investors may be taking Brainard's comments to mean the U.S. economy may remain relatively strong, but will live in a higher-inflation, higher-rate environment going forward. Specifically, Brainard called out the very strong U.S. recovery, which may necessitate a quicker unwinding of the Fed's $9 trillion balance sheet. Brainard continued:
Given that the recovery has been considerably stronger and faster than in the previous cycle, I expect the balance sheet to shrink considerably more rapidly than in the previous recovery, with significantly larger caps and a much shorter period to phase in the maximum caps compared with 2017–19.
While interest rate hikes affect the shorter end of the yield curve, the Fed unwinding its balance sheet quicker than expected could lead to higher long-term rates if it begins selling longer-dated maturity securities. When the Fed was buying long-term U.S. Treasuries, that extra demand had the effect of holding down long-term rates. Brainard is signaling the Fed may now be selling those securities more quickly than expected, which is why the longer-term rates spiked on Tuesday.
In response, the 10-year Treasury Bond yield spiked to 2.554% as of 1:10 p.m. ET, the highest rate since May of 2019.
What does this have to do with Snowflake, Datadog, and HubSpot? Well, these companies are best-in-class software names, displaying remarkably high revenue growth amid long-term trends in the big data economy. However, none of these companies are profitable today, as they aggressively reinvest to capitalize on their growth opportunities.
With profitability far out in the future, their intrinsic value is highly sensitive to long-term interest rates. That's because investors tend to use long-term risk-free rates such as the 10-year Treasury yield as a baseline for discounting future profits. So when the 10-year yield has a big spike up, future profits are discounted by a greater amount in today's dollars, and these stocks tend to fall -- even if they are best-in-class.
Image source: Getty Images.
Now what
No doubt, these stocks are displaying terrific growth, with Snowflake growing revenue 101.5%, Datadog growing 83.7%, and HubSpot seeing revenue up 46.5% last quarter. At the same time, these profit-less stocks also trade at a lofty 59, 46, and 19 times sales, respectively.
Therefore, it is very difficult to navigate these companies' growth opportunities against a high valuation in a changing interest rate regime. If you own or are interested in these three top tech names, you should really have a specific view on their competitive advantage, growth potential, a clear estimate for long-term margins, and when profitability may occur.
Investors should also take care to discount the future by an appropriate rate, consisting of an equity risk premium over long-term risk-free rates. That premium is what investors demand for taking the "risk" of owning equities over Treasuries, and that premium has ranged from anywhere between 2.5% and 6.5% over the last 50 years, according to calculations by NYU valuation professor Aswath Damodaran. Investors should probably use a premium at least in the middle of that range, as too low a premium could lead one to overvalue stocks.
