Why Snowflake, Datadog, and MongoDB Plunged Today

What happened

Shares of high-powered software stocks Snowflake (SNOW -0.26%), Datadog (DDOG 1.19%), and MongoDB (MDB -2.10%) all plunged today, down 7.4%, 6.3%, and 5.4%, respectively, as of 3:45 p.m. ET.

The pain across the technology sector came on the heels of this morning's stronger-than-expected jobs report, which brought back fears of steeper interest rate hikes from the Federal Reserve. Technology stocks, especially high-growth, unprofitable tech stocks with the bulk of their earnings power far in the future, are quite sensitive to long-term interest rates.

Today's losses are really just a give-back from the gains seen earlier this week, when some softer economic data spurred hopes the Fed would ease off the brakes.

So what

These all-star software companies have repeatedly beat revenue estimates this year, but it's not hard to figure out why they're down so much. The culprit was today's September jobs report, which came in slightly stronger than expected, with 266,000 new jobs added and the unemployment rate falling to 3.5%, versus expectations of 255,000 and 3.7%.

In the software industry, a lot of times good news on the economy is bad news for these stocks. That's because the hotter the economy is running, the higher long-term bond yields will go, and the more the Federal Reserve may have to hike interest rates. After falling from around 4% to roughly 3.6% in the beginning of the week on lower job openings data, the 10-year Treasury bond yield is bouncing back higher today, to around 3.88% as of this writing.

As you can see, these companies generate either no profits or significant losses, and they trade on high multiples of their sales. Therefore, when rates go up, future earnings are discounted by a greater amount, compressing their valuations. So it's no surprise to see Snowflake, the most expensive stock, down the most. 

Data source: Yahoo! Finance. YOY = year over year. TTM = trailing 12 months.

As you can see, though Datadog is slightly profitable, none of these companies generate lots of earnings under generally accepted accounting principles (GAAP), and they probably won't for a while as they reinvest in growth. Furthermore, price-to-sales ratios above 10 were once considered expensive, before the recent era of ultra low interest rates since the financial crisis of 2008. So, a 20 or 30-plus price-to-sales ratio is very vulnerable to a sharp rise in interest rates.

Now what

These three stocks have high-growth characteristics and appear to have much-desired products in the new era of big data and artificial intelligence applications. Snowflake is becoming a preferred data lake application for cloud customers, Datadog's observability products appear to have a lead in monitoring crucial software applications, and MongoDB's new-age document database product is becoming widely adopted over traditional relational databases. 

However, that doesn't mean their stocks will perform as well as their businesses. Each stock is still expensive based on conventional metrics, and each is still far, far above their respective initial public offering prices from just a few years ago.

Make no mistake, these are great companies that one should look to own, albeit at the right price. At the very least, they should be on investors' watch lists should software investors eventually capitulate.

Still, these growth stocks are a risky bet, given that it's really not known where interest rates will settle over the next few years, or what these companies' ultimate profit margins will be.

Sure, if inflation comes down fast and bond yields come down to levels seen before inflation spiked, these stocks could go higher again. However, there seems to be more downside risk than upside risk, at least until inflation shows clear and convincing signs of coming down in a big way.