What happened
Shares of enterprise software giants Snowflake (SNOW 2.53%), Datadog (DDOG 0.50%), and MongoDB (MDB 0.81%) were plunging on Monday, down by 8.7%, 6.4%, and 9.4%, respectively, as of 3:06 p.m. ET.
There wasn't much company-specific news today, although Snowflake reported earnings last week, and MongoDB will report tomorrow. Rather, today's moves likely had to do with fears that inflation may not have fallen as much as hoped last month. Friday's strong jobs and wages report, combined with today's stronger-than-expected services Purchasing Managers' Index (PMI) reading, showed the economy may be stronger than generally thought -- surprising, especially since recent financial results and guidance in the software industry have been less than stellar.
Paradoxically, today's strong economic numbers are bad for longer-duration growth stocks, such as these three.
So what
This morning, the U.S. Institute for Supply Management (ISM) released its November data for non-manufacturing PMI. The reading came in at 56.5, increasing from the 54.5 reading in October and higher than the expected 53.3 reading.
This is yet another "good news is bad news" event, as was last week's stronger-than-expected jobs and wages report. Stronger demand for services likely means the Federal Reserve will have to keep on raising interest rates in an effort to tame inflation, whereas many had hoped inflation may be on its way down. In response, the yield on the 10-year Treasury bond rose about 10 basis points today, to 3.6% as of this writing, after falling relatively hard over the past month as investors expected softening economic activity and inflation.
High-growth but unprofitable stocks are especially sensitive to long-term bond yields, because the bulk of these companies' earnings are far out into the future. Thus, it's no surprise to see growth stocks falling today.
These cloud software stocks may also be falling because, despite stronger-than-expected overall services activity, many top software stocks that have reported this earnings season are providing slower-than-expected growth expectations. For instance, shares of Snowflake initially plunged after the company's earnings report last week, before recovering somewhat. Management said it is seeing some slowing as enterprises look to trim costs ahead of a potential recession next year, and it noted pockets of weakness, particularly outside the United States and in small and medium-sized businesses.
So the software sector, which boomed during digitization efforts during the pandemic, may actually be slowing, despite a pickup in overall services activity as seen in the PMI. It's a confusing picture, and potentially a bad omen for cloud stocks that trade at high multiples.
Now what
Despite their year-to-date sell-offs, Snowflake, Datadog, and MongoDB still aren't "cheap" by traditional metrics. Even though they are down between 56% and 70% on the year, these stocks still trade at 23, 15, and 9 times sales, respectively.
Data by YCharts.
While the three companies are in the top of their class in their respective niches, their shares may still face challenges as long as this overhang of services inflation and higher interest rates persists. It will be very hard to identify a bottom in these stocks, especially as the businesses can't be valued based on profits yet.
Still, while I'm not convinced these stocks are done selling off, growth investors should have each on their watch lists. Snowflake is a clear industry leader in cloud data management, and the price is nearly back down to its IPO price of $120. Datadog has posted fantastic growth as a leader in cloud observability, helping enterprises maintain their software applications and identify latency or security issues. And MongoDB is a disruptive leader in a new kind of database that is catching on in the new era of unstructured data, as enterprises look to do more with disparate forms of data for corporate decision-making.
But what is the outlook for the stocks (as opposed to the businesses)? It's a more mixed picture, as valuation is very much a concern in a higher-rate environment. Unfortunately, shares of Snowflake, Datadog, and MongoDB will likely be volatile in the near term, as macro data is released and the expectations for Federal Reserve interest rate hikes change.
