What happened
Shares of Zoom Video Communications (ZM -0.62%), Datadog (DDOG 0.53%), and MongoDB (MDB -0.10%) each fell hard on Wednesday, with the stocks down 4.8%, 6.9%, and 7%, respectively, as of 1:48 p.m. ET.
None of the above reported material news today, so the declines were likely due to marketwide selling in technology stocks, specifically highly valued enterprise software names like these. That's been the result of some recent hawkish commentary from several Federal Reserve officials, who seem to be preparing the market for steep interest rate hikes.
So what
The aforementioned software stocks were darlings of the pandemic. As high-growth stocks with profits far out into the future, these stocks benefited when the Fed cut interest rates to zero. Meanwhile, usage of these new, "stay-at-home" tools helped businesses thrive during lockdowns. Therefore, these names saw an acceleration of growth.
However, it appears the pendulum has now swung the other way. The U.S. is coming out of the pandemic with a vengeance, with high inflation. Yesterday, Lael Brainard, known as one of the more dovish Fed officials, gave a decidedly hawkish speech, implying that the Fed would do what it takes to get inflation down -- perhaps even if that means slowing the economy or even pushing it into recession.
Then today, another Fed official, Philadelphia Fed President Patrick Harker, told the Delaware Chamber of Commerce:
Inflation is running far too high, and I am acutely concerned about this. ... The bottom line is that generous fiscal policies, supply chain disruptions and accommodative monetary policy have pushed inflation far higher than I -- and my colleagues on the [Federal Open Market Committee] -- are comfortable with. I'm also worried that inflation expectations could become unmoored.
The Fed is clearly telegraphing it will hike rates more than some might expect, and that it wants economic activity to slow down. That scenario isn't particularly good for stocks, especially growth stocks. Moreover, the Fed will begin reducing the amount of securities on its balance sheet next month. Therefore, Treasury bonds and mortgage-backed securities will lose a big buyer, meaning other private companies such as banks will need to buy them, and they will likely demand a higher yield.
That has the potential to keep long-term Treasury bond yields on the rise. Wednesday saw the 10-year yield rise as high as 2.64%, before settling in around 2.60%. However, that's up nearly 30 basis points in less than five days, which is a pretty quick increase.
Stock investors typically use a discount rate to discount the value of future earnings, and this rate is usually based on the 10-year Treasury yield, plus a premium. So if long-term Treasury yields rise, discount rates go up, and the value of earnings far out in the future go down.
Both Datadog and MongoDB are growing strongly, but have negative earnings at the moment, with the bulk of their value well out into the future. Zoom is actually cheaper, but still trades at 32 times this year's earnings estimates. That's not cheap, and some are worried about slowing growth for Zoom as the pandemic eases, as well as heightened competition in the video conferencing space.
During the pandemic, these names soared because we had a recession, but with low rates and a helpful Federal Reserve. However, in an inflationary recession with rising rates, these stocks aren't working, reversing some of those gains.
Image source: Getty Images.
Now what
It's a bit difficult to know what to do with these stocks at the moment. Each is a really high-quality company disrupting the enterprise computing space and showing impressive growth, especially Datadog and MongoDB.
On the other hand, these stocks are also very highly valued -- Datadog and MongoDB in particular trade at 47 and 32 times sales, respectively. Warren Buffett has long said that it's possible to pay too high a price even for terrific companies. After a very strong multi-year run, it looks as though these stocks are in for a difficult valuation reset.
On the other hand, over the long term -- as in, years from now -- each of these stocks appears to have a bright future. So while current holders may need to brace for more near-term pain, those interested in these stocks may want to look for an entry point as they fall back to earth.
