What happened
Shares of fintech firms Upstart (UPST -3.09%), SoFi Technologies (SOFI -0.73%), and Affirm (AFRM -1.09%) were rallying today, up 6.1%, 3.7%, and 7.9%, respectively, as of 3:36 p.m. ET.
These three stocks are down severely this year and are rising off their all-time lows, so a big daily move up is not surprising. The question is, do today's reasons for their rise indicate a bottom, or just a dead-cat bounce?
So what
Today's rally appears to be all about interest rates.
First, some context. Fintech stocks such as these three have been some of the worst performers over the past year. Therefore, if the trends that caused the drawdown reverse, it stands to reason fintech stocks might rally harder coming out of this -- that is, if these companies make it through a potential recession.
The fall in this sector is due to two negative trends working in concert. First, these up-and-coming companies have set their sites on disrupting traditional finance, so they were spending heavily on growth, innovation, and customer acquisition, while either making very little profit or burning cash outright.
Unprofitable growth stocks have had a very difficult time, ever since inflation and interest rates rose toward the end of last year. This is because higher long-term interest rates lower the present value of future profits, all else being equal. Given that these stocks have basically all of their potential profitability well out into the future, that harms valuation.
But fintech stocks are also vulnerable in a second way, as the Federal Reserve raises interest rates in order to tame inflation. That's because many believe the Fed will have to induce a recession in order to get inflation back under control. While not a certainty, history does not give very favorable odds to a "soft landing," in which inflation declines without a recession.
Since these fintech companies, particularly Upstart and Affirm, are perceived to lend to less credit-worthy borrowers, some fear charge-offs will also hurt earnings and potentially put these companies' liquidity in jeopardy.
Upstart uses artificial intelligence to underwrite loans to borrowers that may have underrated FICO scores or would otherwise be denied loans they should qualify for -- at least in Upstart's eyes.
Upstart's models did show higher-than-expected charge-offs earlier this year, as its 2021 vintages were underwritten before inflation rocketed higher unexpectedly. Management has maintained it adjusted its models to suit the new environment, but investors seem to have lost faith and are still skeptical. Shares are down a stunning 94% from their all-time highs.
Affirm is a pioneer in the "buy now, pay later" space, which has also drawn lots of investor skepticism. Since these offerings tend to help cash-strapped consumers pay for big-ticket items over time, some may suspect they will see lots of defaults if unemployment rises.
SoFi caters to more well-off borrowers, as the company targets grad school students with student loans and then sells them more financial products over time. However, the company is currently unprofitable on a GAAP basis, having lost $387 million over the past 12 months. So even though it should have a better borrower base, investors are currently concerned over how to value this money-losing stock.
So why are these stocks bouncing today? Since higher inflation and interest rates are causing both concerns, today's easing of long-term interest rates off their recent highs is likely fueling the big gains. After hitting a 4% yield, the highest in more than a decade, the 10-year Treasury bond yield is falling today in a big way, dropping from 4% to 3.73% as of this writing.
That amounts to a big relief for growth stocks in general, including fintech stocks such as these three.
Now what
While still containing a fair amount of risk, these three stocks are down huge from their all-time highs. Therefore, should these three make it through a potential recession, or if the economy avoids a recession, the upside could be very big.
Those looking for bargains should dig into each company's business model, balance sheet, and management to judge for themselves. If you gain confidence that the company has what it takes to make it through even an adverse recession, these types of stocks could have the biggest upside coming out of this period.
Just be aware that these are still young companies that are appropriate only for growth-oriented investors. Older investors who can't afford volatility should probably stick with more established, high-quality blue chips that pay out consistent dividends.
