What happened
Shares of big data and AI-focused software companies C3.ai (AI -7.09%), Palantir (PLTR -3.40%), and Appian (APPN -1.25%) were falling hard on Tuesday -- down 8.3%, 6.9%, and 6.4%, respectively, as of 1:13 p.m. ET.
There was one negative piece of news for Palantir Tuesday, as an analyst warned of some big risks later in 2023 despite the strong earnings results it reported last week. However, C3.ai also had a bit of positive news -- it announced a closer collaboration and partnership with leading cloud platform Amazon Web Services.
Still, the across-the-board declines in this space suggest that macroeconomic elements are the key factor. Tuesday's declines appear mainly to have to do with the rapid rise in long-term bond yields, which have come up noticeably from their lows and are heading back toward 4% -- a level not seen since autumn.
So what
On Tuesday, the 10-year Treasury bond yield rose by about 9 basis points (or 2.38%) to a yield of 3.92% as of this writing. That's a fairly big one-day move, and was almost the exact inverse of the stock market's move lower. The 10-year yield is now about half a percentage point higher than its 2023 low of just under 3.4%, which occurred in early February -- perhaps not coincidentally, around the time the recent run in the stock market peaked. However, the 10-year yield is still a good bit lower than its peak of 4.33% in October -- when the stock market was at its recent low.
The catalyst for the recent rise in long-term bond yields was the stronger-than-expected January jobs report and last week's January inflation data, which seemed to reverse the downward trend of the prior three months. Whether or not the strong report is just due to seasonal noise or a snap-back in inflationary pressures is difficult to know, but it appears investors now believe inflation may prove more difficult for the Federal Reserve to get in check than they had thought in early January.
Why are stocks -- and especially growth stocks -- so sensitive to moves in the 10-year yield? It's because a company's intrinsic value is the present value of its future cash flows. That present value is determined in part by interest rates, plus a risk premium. While many are obsessing about how far the Federal Reserve will lift the federal funds rate -- the key short-term interest rate benchmark -- equity investors likely use longer-term bond yields as their baselines for discounting companies' long-term future earnings.
C3.ai, Palantir, and Appian are all growth stocks that are booking little to no profits now. The vast majority of their anticipated earnings will come well in the future. So it's no surprise that rising bond rates are hitting these types of stocks the hardest.
Moreover, each of these stocks has already had a big year-to-date run-up. This was due to enthusiasm over falling inflation and long-term interest rates seen over the prior three months, as well as excitement about artificial intelligence and the use of big data.
AI Year-to-Date Total Returns (Daily) data by YCharts.
C3.ai has a number of AI-related software platforms, Palantir helps both the U.S. government and large enterprises turn their vast troves of data into real-time insights, and Appian's low-code software helps enterprises to automate complex business processes and operations. Given moderating inflation to start the year, as well as investor enthusiasm for anything related to AI thanks to the release of OpenAI's ChatGPT late last year, all three stocks have seen handsome year-to-date gains, even after Tuesday's sell-off.
Palantir also received a downbeat note Tuesday from William Blair analyst Louie DiPalma. Palantir surged last week following its fourth-quarter earnings report, which showed solid growth and a surprise GAAP net profit. However, DiPalma sees stormier times ahead. Specifically, he notes that a large number of the company's government contracts are up for renewal over the next 15 months or so, and the government appears to be assessing whether it can switch from Palantir's expensive software stack to lower-cost open-source solutions.
If any of its large contracts aren't renewed, it could potentially be disastrous for Palantir, which still gets the majority of its revenue from these big government contracts.
Now what
There is no doubt that big data, artificial intelligence, and advanced analytics will be important to governments and enterprises going forward. One can look at C3.ai's expansion of its partnership with AWS as an example of that. In fact, the expanded partnership appears to be in the field of law enforcement and defense software -- which could potentially put it into competition against Palantir.
Yet while the future of AI is bright, a stock's value is determined by its future cash flows and interest rates. Given that AI is a young industry, many more players will no doubt come into it. The impact of that increasing competition is something Palantir appears to be experiencing. That pressure will affect these companies' future profitability. Meanwhile, the fact that these businesses are generally unprofitable or not very profitable so far makes them particularly susceptible to rising long-term interest rates.
So while you as an investor should be assessing the various rising players in the field of AI, you should also curb your enthusiasm as to the prices you are willing to pay for their shares. Tuesday's sell-off is an unpleasant reminder of why.
