What happened
Shares of high-growth but no-profit tech stocks are surging higher today, with investor favorites Snowflake (SNOW 2.69%), Datadog (DDOG 3.58%), and HubSpot (HUBS 2.96%) rallying 7.7%, 7.1%, and 6.7%, respectively, as of 1:38 p.m. EST.
There wasn't much in the way of company-specific news today. However, high-growth stocks with current operating losses have proven to be extremely sensitive to the interest-rate and inflation picture over the past year.
Not only did these stocks surge following Fed Chair Jay Powell's press conference late yesterday, but another economic report on labor productivity this morning added to the massive surge of optimism that the post-pandemic inflation spike is over, with rate-sensitive stocks across tech, financials, and consumer discretionary stocks all rallying today.
So what
These software-as-a-service (SaaS) stocks continue to post impressive top-line metrics, as each has developed best-in-class tools related to digital transformation.
Snowflake has pioneered a cutting-edge platform for enterprises to manage data across a wide range of clouds and other data silos that help businesses make better decisions. Datadog is a leader in observability, which enables organizations to monitor and track their increasingly complex IT environments in real time. And HubSpot has developed a leading digital-marketing and customer-relationship management software stack for businesses of all sizes.
However, as these companies see a big growth opportunity, they have to invest heavily in top tech talent to seize it, resulting in operating losses. With no current profits and trading at relatively high valuations based on their sales, their lack of profitability makes valuing these stocks rather difficult.
For any growth stock, there is a wide range of valuation possibilities, but an inflationary environment is the worst kind of setting for them. This is because the entirety of any profitless growth stock's value lies in its future profits. If inflation and interest rates are high, those future profits will be worth much less than they would be if they were earned today.
That's why these stocks have reacted so favorably to recent declining inflation data, which have significantly eased since November. Yet a final concern has been that the Federal Reserve's interest rate hikes, which have been successful in slowing inflation, would go too far and push the economy into a recession. That would crimp near-term growth of even the best stocks. Fed officials had maintained a very hawkish tone in recent public appearances, which scared market participants as recently as December.
However, after yesterday's decision to raise the federal funds rate by just 25 basis points, Chairman Jay Powell seemed to strike a more optimistic and conciliatory tone on further hikes and inflation. Powell finally acknowledged that the data have been showing significant "disinflation" -- a word he hadn't used at any of his previous press conferences -- while also signaling perhaps only a couple more small rate increases, if any.
In addition, Powell expressed optimism that getting to the Fed's 2% inflation target could happen without significant job losses, saying,
I think most forecasters would say that unemployment will probably rise a bit... But I continue to think that there's a path to getting inflation back down to 2% without a really significant economic decline or a significant increase in unemployment.
While much of the media's attention remains on yesterday's press conference, that "soft landing" hope got yet another positive data point this morning. Today, the Labor Department released fourth-quarter Nonfarm Productivity data. Q4 productivity growth came in at a 3% annualized growth rate -- higher than the 2.4% expected rate. In addition, Q3's productivity numbers were revised higher to 1.4%, versus the initial 0.8% metric. Of note, productivity still fell 1.3% for all of 2022 but appears to be reversing its declines into an upward trajectory.
Related to this, unit labor costs rose at just a 1.1% annualized rate, slower than the 2% rate in Q3 and 5.7% for all of 2022.
Unit labor costs and productivity metrics are key for the Fed, because the post-pandemic labor shortage has led to wage growth that has been too high to sustain the Fed's 2% inflation target. If companies need to pay more for labor to produce one unit of a product or service, that could lead to higher and "stickier" inflation.
However, if productivity is now recovering from the pandemic and unit costs are moderating, that means inflationary pressures are fading without damaging output. That should enable the Fed to slow down on interest rate hikes and increase the chances of threading the needle for a "soft landing."
SNOW PS Ratio data by YCharts.
Now what
While it may look as if tech investors are now in the clear, just remember that things are still far from certain. The post-pandemic environment has been strange, as most economists didn't see the rapid increase in inflation last year or the rapid disinflation now.
As you can see above, these three stocks still don't look "cheap" by conventional metrics. That means they could remain highly volatile should the interest rate environment change or if these companies encounter any internal or competition-related setbacks.
Of note, high-growth stocks that spent heavily on growth in the low-rate, pre-pandemic era now understand investors will want to see profits sooner or later. On that note, earlier this week, HubSpot did announce a 7% workforce reduction as it is taking this opportunity to streamline its business and boost its bottom line. It is possible that once these high-growth stocks pivot to making profits, investors may be underwhelmed.
So, high-growth, no-profit stocks with high price-to-sales ratios over 10 still remain a risk, in my view. While they have potentially exciting futures, these three only remain appropriate for younger investors with a long time horizon as older investors should gravitate toward more profitable stocks that return cash to shareholders today.
